David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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, Shenzhen Neptunus Bioengineering Co., Ltd. (SZSE:000078) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for Shenzhen Neptunus Bioengineering

What Is Shenzhen Neptunus Bioengineering's Debt?

As you can see below, at the end of June 2023, Shenzhen Neptunus Bioengineering had CN¥12.2b of debt, up from CN¥11.4b a year ago. Click the image for more detail. On the flip side, it has CN¥3.78b in cash leading to net debt of about CN¥8.42b.

How Strong Is Shenzhen Neptunus Bioengineering's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Neptunus Bioengineering had liabilities of CN¥29.8b falling due within a year, and liabilities of CN¥398.7m due beyond that. Offsetting this, it had CN¥3.78b in cash and CN¥23.4b in receivables that were due within 12 months. So its liabilities total CN¥3.10b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Shenzhen Neptunus Bioengineering is worth CN¥8.03b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.89 times and a disturbingly high net debt to EBITDA ratio of 8.7 hit our confidence in Shenzhen Neptunus Bioengineering like a one-two punch to the gut. The debt burden here is substantial. Worse, Shenzhen Neptunus Bioengineering's EBIT was down 36% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shenzhen Neptunus Bioengineering's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Shenzhen Neptunus Bioengineering's free cash flow amounted to 42% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Shenzhen Neptunus Bioengineering's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. It's also worth noting that Shenzhen Neptunus Bioengineering is in the Healthcare industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Shenzhen Neptunus Bioengineering's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. To that end, you should be aware of the 2 warning signs we've spotted with Shenzhen Neptunus Bioengineering .

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.

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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.