Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Apeloa Pharmaceutical Co.,Ltd (SZSE:000739) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Apeloa PharmaceuticalLtd's Debt?

As you can see below, Apeloa PharmaceuticalLtd had CN¥963.1m of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has CN¥3.72b in cash, leading to a CN¥2.75b net cash position.

How Healthy Is Apeloa PharmaceuticalLtd's Balance Sheet?

According to the last reported balance sheet, Apeloa PharmaceuticalLtd had liabilities of CN¥6.77b due within 12 months, and liabilities of CN¥226.6m due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.72b as well as receivables valued at CN¥2.86b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥424.3m.

Given Apeloa PharmaceuticalLtd has a market capitalization of CN¥15.7b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Apeloa PharmaceuticalLtd also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, Apeloa PharmaceuticalLtd saw its EBIT drop by 2.7% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Apeloa PharmaceuticalLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Apeloa PharmaceuticalLtd 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. Looking at the most recent three years, Apeloa PharmaceuticalLtd recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Apeloa PharmaceuticalLtd has CN¥2.75b in net cash. So we are not troubled with Apeloa PharmaceuticalLtd's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Apeloa PharmaceuticalLtd .

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.

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