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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Guangzhou Baiyunshan Pharmaceutical Holdings Company Limited (HKG:874) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 Guangzhou Baiyunshan Pharmaceutical Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Guangzhou Baiyunshan Pharmaceutical Holdings had debt of CN¥13.5b, up from CN¥11.6b in one year. But it also has CN¥17.5b in cash to offset that, meaning it has CN¥3.98b net cash.

A Look At Guangzhou Baiyunshan Pharmaceutical Holdings' Liabilities

We can see from the most recent balance sheet that Guangzhou Baiyunshan Pharmaceutical Holdings had liabilities of CN¥36.3b falling due within a year, and liabilities of CN¥4.94b due beyond that. Offsetting these obligations, it had cash of CN¥17.5b as well as receivables valued at CN¥22.0b due within 12 months. So its liabilities total CN¥1.72b more than the combination of its cash and short-term receivables.

Since publicly traded Guangzhou Baiyunshan Pharmaceutical Holdings shares are worth a total of CN¥43.1b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Guangzhou Baiyunshan Pharmaceutical Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Guangzhou Baiyunshan Pharmaceutical Holdings's EBIT dived 17%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Guangzhou Baiyunshan Pharmaceutical Holdings'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Guangzhou Baiyunshan Pharmaceutical Holdings 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. Looking at the most recent three years, Guangzhou Baiyunshan Pharmaceutical Holdings recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

We could understand if investors are concerned about Guangzhou Baiyunshan Pharmaceutical Holdings's liabilities, but we can be reassured by the fact it has has net cash of CN¥3.98b. So we don't have any problem with Guangzhou Baiyunshan Pharmaceutical Holdings'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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Guangzhou Baiyunshan Pharmaceutical Holdings (of which 1 is a bit concerning!) 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.

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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.