Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Sinopharm Group Co. Ltd. (HKG:1099) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Sinopharm Group's Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Sinopharm Group had debt of CN¥68.6b, up from CN¥64.7b in one year. On the flip side, it has CN¥63.8b in cash leading to net debt of about CN¥4.76b.

How Healthy Is Sinopharm Group's Balance Sheet?

We can see from the most recent balance sheet that Sinopharm Group had liabilities of CN¥241.5b falling due within a year, and liabilities of CN¥21.6b due beyond that. On the other hand, it had cash of CN¥63.8b and CN¥185.8b worth of receivables due within a year. So it has liabilities totalling CN¥13.5b more than its cash and near-term receivables, combined.

Sinopharm Group has a market capitalization of CN¥56.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sinopharm Group's net debt is only 0.19 times its EBITDA. And its EBIT covers its interest expense a whopping 10.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. While Sinopharm Group doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Sinopharm 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Sinopharm Group produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Sinopharm Group's demonstrated ability handle its debt, based on its EBITDA, delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its interest cover is also very heartening. We would also note that Healthcare industry companies like Sinopharm Group commonly do use debt without problems. Taking all this data into account, it seems to us that Sinopharm Group takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Given Sinopharm Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.

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.