The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Hansoh Pharmaceutical Group Company Limited (HKG:3692) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Hansoh Pharmaceutical Group's Net Debt?

As you can see below, Hansoh Pharmaceutical Group had CN¥4.22b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥22.9b in cash, so it actually has CN¥18.7b net cash.

How Healthy Is Hansoh Pharmaceutical Group's Balance Sheet?

According to the last reported balance sheet, Hansoh Pharmaceutical Group had liabilities of CN¥6.86b due within 12 months, and liabilities of CN¥381.5m due beyond 12 months. Offsetting these obligations, it had cash of CN¥22.9b as well as receivables valued at CN¥3.21b due within 12 months. So it can boast CN¥18.9b more liquid assets than total liabilities.

This surplus suggests that Hansoh Pharmaceutical Group is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Hansoh Pharmaceutical Group has more cash than debt is arguably a good indication that it can manage its debt safely.

Fortunately, Hansoh Pharmaceutical Group grew its EBIT by 3.8% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hansoh Pharmaceutical Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Hansoh Pharmaceutical Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Hansoh Pharmaceutical Group recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case Hansoh Pharmaceutical Group has CN¥18.7b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥1.8b, being 78% of its EBIT. So is Hansoh Pharmaceutical Group's debt a risk? It doesn't seem so to us. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Hansoh Pharmaceutical Group's earnings per share history for free.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.