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. Importantly, Guobang Pharma Ltd. (SHSE:605507) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Guobang Pharma's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Guobang Pharma had CN¥1.08b of debt, an increase on CN¥914.1m, over one year. But it also has CN¥1.87b in cash to offset that, meaning it has CN¥791.7m net cash.

How Strong Is Guobang Pharma's Balance Sheet?

We can see from the most recent balance sheet that Guobang Pharma had liabilities of CN¥2.26b falling due within a year, and liabilities of CN¥250.6m due beyond that. On the other hand, it had cash of CN¥1.87b and CN¥1.26b worth of receivables due within a year. So it can boast CN¥616.0m more liquid assets than total liabilities.

This short term liquidity is a sign that Guobang Pharma could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Guobang Pharma has more cash than debt is arguably a good indication that it can manage its debt safely.

On the other hand, Guobang Pharma's EBIT dived 13%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guobang Pharma can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Guobang Pharma 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 three years, Guobang Pharma 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

While we empathize with investors who find debt concerning, you should keep in mind that Guobang Pharma has net cash of CN¥791.7m, as well as more liquid assets than liabilities. So we don't have any problem with Guobang Pharma's use of debt. There's no doubt that we learn most about debt from the balance sheet. 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 Guobang Pharma .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.