Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Cathay Biotech Inc. (SHSE:688065) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

How Much Debt Does Cathay Biotech Carry?

The image below, which you can click on for greater detail, shows that at March 2024 Cathay Biotech had debt of CN¥1.68b, up from CN¥1.42b in one year. However, its balance sheet shows it holds CN¥4.99b in cash, so it actually has CN¥3.31b net cash.

How Strong Is Cathay Biotech's Balance Sheet?

We can see from the most recent balance sheet that Cathay Biotech had liabilities of CN¥2.75b falling due within a year, and liabilities of CN¥1.00b due beyond that. Offsetting these obligations, it had cash of CN¥4.99b as well as receivables valued at CN¥440.1m due within 12 months. So it can boast CN¥1.67b more liquid assets than total liabilities.

This surplus suggests that Cathay Biotech has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Cathay Biotech has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Cathay Biotech if management cannot prevent a repeat of the 33% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Cathay Biotech 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. Cathay Biotech may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Cathay Biotech saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Cathay Biotech has net cash of CN¥3.31b, as well as more liquid assets than liabilities. So although we see some areas for improvement, we're not too worried about Cathay Biotech's balance sheet. 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. For example, we've discovered 1 warning sign for Cathay Biotech that you should be aware of before investing here.

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