Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Zhejiang Tianyu Pharmaceutical Co., Ltd. (SZSE:300702) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Zhejiang Tianyu Pharmaceutical Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2023 Zhejiang Tianyu Pharmaceutical had CN¥1.75b of debt, an increase on CN¥1.02b, over one year. However, it does have CN¥434.1m in cash offsetting this, leading to net debt of about CN¥1.31b.
How Healthy Is Zhejiang Tianyu Pharmaceutical's Balance Sheet?
According to the last reported balance sheet, Zhejiang Tianyu Pharmaceutical had liabilities of CN¥2.57b due within 12 months, and liabilities of CN¥233.2m due beyond 12 months. Offsetting these obligations, it had cash of CN¥434.1m as well as receivables valued at CN¥515.0m due within 12 months. So it has liabilities totalling CN¥1.85b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Zhejiang Tianyu Pharmaceutical has a market capitalization of CN¥6.18b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Zhejiang Tianyu Pharmaceutical has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 2.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Zhejiang Tianyu Pharmaceutical grew its EBIT a smooth 77% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Zhejiang Tianyu Pharmaceutical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Zhejiang Tianyu Pharmaceutical burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Neither Zhejiang Tianyu Pharmaceutical's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Zhejiang Tianyu Pharmaceutical's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Even though Zhejiang Tianyu Pharmaceutical lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.