Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Sichuan Hebang Biotechnology Corporation Limited (SHSE:603077) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. 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 Sichuan Hebang Biotechnology Carry?

As you can see below, at the end of March 2024, Sichuan Hebang Biotechnology had CN¥2.96b of debt, up from CN¥1.63b a year ago. Click the image for more detail. However, it also had CN¥2.78b in cash, and so its net debt is CN¥174.0m.

How Strong Is Sichuan Hebang Biotechnology's Balance Sheet?

According to the last reported balance sheet, Sichuan Hebang Biotechnology had liabilities of CN¥5.09b due within 12 months, and liabilities of CN¥874.3m due beyond 12 months. On the other hand, it had cash of CN¥2.78b and CN¥2.62b worth of receivables due within a year. So it has liabilities totalling CN¥563.9m more than its cash and near-term receivables, combined.

Of course, Sichuan Hebang Biotechnology has a market capitalization of CN¥13.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Sichuan Hebang Biotechnology has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Sichuan Hebang Biotechnology has very modest net debt levels, with net debt at just 0.087 times EBITDA. Happily, it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like an Olympic ice-skater handles a pirouette. In fact Sichuan Hebang Biotechnology's saving grace is its low debt levels, because its EBIT has tanked 73% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sichuan Hebang Biotechnology will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Sichuan Hebang Biotechnology reported free cash flow worth 16% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Sichuan Hebang Biotechnology's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Sichuan Hebang Biotechnology's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Sichuan Hebang Biotechnology , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com