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.' 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. We can see that Youcare Pharmaceutical Group Co., Ltd. (SHSE:688658) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Youcare Pharmaceutical Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Youcare Pharmaceutical Group had CN¥670.9m of debt, an increase on CN¥228.8m, over one year. However, it does have CN¥1.73b in cash offsetting this, leading to net cash of CN¥1.06b.

A Look At Youcare Pharmaceutical Group's Liabilities

We can see from the most recent balance sheet that Youcare Pharmaceutical Group had liabilities of CN¥2.04b falling due within a year, and liabilities of CN¥428.9m due beyond that. Offsetting this, it had CN¥1.73b in cash and CN¥1.06b in receivables that were due within 12 months. So it actually has CN¥324.4m more liquid assets than total liabilities.

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

In fact Youcare Pharmaceutical Group's saving grace is its low debt levels, because its EBIT has tanked 38% in the last twelve months. 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 it is future earnings, more than anything, that will determine Youcare Pharmaceutical Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Youcare Pharmaceutical Group 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, Youcare Pharmaceutical Group barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Youcare Pharmaceutical Group has net cash of CN¥1.06b, as well as more liquid assets than liabilities. So we are not troubled with Youcare Pharmaceutical Group's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Youcare Pharmaceutical Group (of which 1 doesn't sit too well with us!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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