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.' 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 Hisun Pharmaceutical Co., Ltd. (SHSE:600267) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 Zhejiang Hisun Pharmaceutical's Debt?
You can click the graphic below for the historical numbers, but it shows that Zhejiang Hisun Pharmaceutical had CN¥5.66b of debt in December 2023, down from CN¥6.38b, one year before. On the flip side, it has CN¥1.59b in cash leading to net debt of about CN¥4.08b.
How Strong Is Zhejiang Hisun Pharmaceutical's Balance Sheet?
We can see from the most recent balance sheet that Zhejiang Hisun Pharmaceutical had liabilities of CN¥6.58b falling due within a year, and liabilities of CN¥2.68b due beyond that. On the other hand, it had cash of CN¥1.59b and CN¥2.27b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.41b.
While this might seem like a lot, it is not so bad since Zhejiang Hisun Pharmaceutical has a market capitalization of CN¥9.71b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Zhejiang Hisun Pharmaceutical's net debt is 2.6 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, Zhejiang Hisun Pharmaceutical's EBIT fell a jaw-dropping 44% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Zhejiang Hisun 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Zhejiang Hisun Pharmaceutical actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Our View
Based on what we've seen Zhejiang Hisun Pharmaceutical is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Zhejiang Hisun Pharmaceutical's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Zhejiang Hisun Pharmaceutical that you should be aware of before investing here.
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.