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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Shandong Lukang Pharmaceutical Co.,Ltd. (SHSE:600789) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Shandong Lukang PharmaceuticalLtd Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Shandong Lukang PharmaceuticalLtd had debt of CN¥2.83b, up from CN¥2.56b in one year. On the flip side, it has CN¥900.4m in cash leading to net debt of about CN¥1.93b.

How Strong Is Shandong Lukang PharmaceuticalLtd's Balance Sheet?

The latest balance sheet data shows that Shandong Lukang PharmaceuticalLtd had liabilities of CN¥3.47b due within a year, and liabilities of CN¥1.63b falling due after that. Offsetting this, it had CN¥900.4m in cash and CN¥1.51b in receivables that were due within 12 months. So its liabilities total CN¥2.69b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shandong Lukang PharmaceuticalLtd has a market capitalization of CN¥7.46b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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.

Shandong Lukang PharmaceuticalLtd has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 3.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, Shandong Lukang PharmaceuticalLtd grew its EBIT by 21% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong Lukang PharmaceuticalLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Shandong Lukang PharmaceuticalLtd's free cash flow amounted to 29% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Shandong Lukang PharmaceuticalLtd's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. Looking at all this data makes us feel a little cautious about Shandong Lukang PharmaceuticalLtd'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. 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 3 warning signs we've spotted with Shandong Lukang PharmaceuticalLtd .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.