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. Importantly, Kangmei Pharmaceutical Co., Ltd. (SHSE:600518) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Kangmei Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Kangmei Pharmaceutical had debt of CN¥30.0m, up from CN¥26.0m in one year. But on the other hand it also has CN¥744.8m in cash, leading to a CN¥714.8m net cash position.

How Healthy Is Kangmei Pharmaceutical's Balance Sheet?

According to the last reported balance sheet, Kangmei Pharmaceutical had liabilities of CN¥4.63b due within 12 months, and liabilities of CN¥2.49b due beyond 12 months. Offsetting this, it had CN¥744.8m in cash and CN¥2.95b in receivables that were due within 12 months. So it has liabilities totalling CN¥3.42b more than its cash and near-term receivables, combined.

Given Kangmei Pharmaceutical has a market capitalization of CN¥28.0b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Kangmei Pharmaceutical also has more cash than debt, so we're pretty confident it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Kangmei Pharmaceutical turned things around in the last 12 months, delivering and EBIT of CN¥240m. There's no doubt that we learn most about debt from the balance sheet. But it is Kangmei Pharmaceutical'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Kangmei Pharmaceutical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, Kangmei Pharmaceutical saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

Although Kangmei Pharmaceutical's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥714.8m. So we don't have any problem with Kangmei Pharmaceutical's use of debt. 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. We've identified 1 warning sign with Kangmei Pharmaceutical , 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