Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, PharmaBlock Sciences (Nanjing), Inc. (SZSE:300725) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is PharmaBlock Sciences (Nanjing)'s Net Debt?
The chart below, which you can click on for greater detail, shows that PharmaBlock Sciences (Nanjing) had CN¥1.85b in debt in September 2023; about the same as the year before. However, because it has a cash reserve of CN¥1.24b, its net debt is less, at about CN¥612.3m.
A Look At PharmaBlock Sciences (Nanjing)'s Liabilities
We can see from the most recent balance sheet that PharmaBlock Sciences (Nanjing) had liabilities of CN¥1.01b falling due within a year, and liabilities of CN¥1.40b due beyond that. Offsetting this, it had CN¥1.24b in cash and CN¥453.3m in receivables that were due within 12 months. So its liabilities total CN¥716.3m more than the combination of its cash and short-term receivables.
Since publicly traded PharmaBlock Sciences (Nanjing) shares are worth a total of CN¥6.09b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
PharmaBlock Sciences (Nanjing)'s net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 25.4 times, makes us even more comfortable. The bad news is that PharmaBlock Sciences (Nanjing) saw its EBIT decline by 11% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine PharmaBlock Sciences (Nanjing)'s ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, PharmaBlock Sciences (Nanjing) saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
PharmaBlock Sciences (Nanjing)'s conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that PharmaBlock Sciences (Nanjing) is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with PharmaBlock Sciences (Nanjing) , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.