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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Hunan Warrant Pharmaceutical Co.,Ltd (SHSE:688799) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Hunan Warrant PharmaceuticalLtd's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Hunan Warrant PharmaceuticalLtd had debt of CN¥69.9m, up from none in one year. But on the other hand it also has CN¥739.8m in cash, leading to a CN¥669.9m net cash position.

A Look At Hunan Warrant PharmaceuticalLtd's Liabilities

We can see from the most recent balance sheet that Hunan Warrant PharmaceuticalLtd had liabilities of CN¥338.9m falling due within a year, and liabilities of CN¥122.0m due beyond that. Offsetting this, it had CN¥739.8m in cash and CN¥233.5m in receivables that were due within 12 months. So it can boast CN¥512.5m more liquid assets than total liabilities.

This short term liquidity is a sign that Hunan Warrant PharmaceuticalLtd could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Hunan Warrant PharmaceuticalLtd boasts net cash, so it's fair to say it does not have a heavy debt load!

But the other side of the story is that Hunan Warrant PharmaceuticalLtd saw its EBIT decline by 8.9% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hunan Warrant PharmaceuticalLtd's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. While Hunan Warrant PharmaceuticalLtd 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, Hunan Warrant PharmaceuticalLtd reported free cash flow worth 19% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hunan Warrant PharmaceuticalLtd has net cash of CN¥669.9m, as well as more liquid assets than liabilities. So we don't have any problem with Hunan Warrant PharmaceuticalLtd'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. Be aware that Hunan Warrant PharmaceuticalLtd is showing 1 warning sign in our investment analysis , you should know about...

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.