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 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. We can see that China Resources Pharmaceutical Group Limited (HKG:3320) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for China Resources Pharmaceutical Group
How Much Debt Does China Resources Pharmaceutical Group Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2024 China Resources Pharmaceutical Group had CN¥74.9b of debt, an increase on CN¥71.8b, over one year. However, it does have CN¥33.1b in cash offsetting this, leading to net debt of about CN¥41.8b.
How Healthy Is China Resources Pharmaceutical Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Resources Pharmaceutical Group had liabilities of CN¥144.0b due within 12 months and liabilities of CN¥25.2b due beyond that. On the other hand, it had cash of CN¥33.1b and CN¥114.5b worth of receivables due within a year. So its liabilities total CN¥21.7b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of CN¥32.2b, so it does suggest shareholders should keep an eye on China Resources Pharmaceutical Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt to EBITDA of 2.9 China Resources Pharmaceutical Group has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.3 times its interest expense, and its net debt to EBITDA, was quite high, at 2.9. One way China Resources Pharmaceutical Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. 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 China Resources Pharmaceutical Group'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, China Resources Pharmaceutical Group generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Our View
When it comes to the balance sheet, the standout positive for China Resources Pharmaceutical Group was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that China Resources Pharmaceutical Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for China Resources Pharmaceutical Group you should know about.
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.