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.' 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. Importantly, NanJing Pharmaceutical Company Limited (SHSE:600713) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is NanJing Pharmaceutical's Debt?

As you can see below, NanJing Pharmaceutical had CN¥11.1b of debt at September 2024, down from CN¥12.8b a year prior. However, it also had CN¥1.16b in cash, and so its net debt is CN¥9.96b.

How Healthy Is NanJing Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that NanJing Pharmaceutical had liabilities of CN¥19.7b due within 12 months and liabilities of CN¥5.18b due beyond that. Offsetting this, it had CN¥1.16b in cash and CN¥21.4b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.31b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since NanJing Pharmaceutical has a market capitalization of CN¥7.18b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 6.0, it's fair to say NanJing Pharmaceutical does have a significant amount of debt. However, its interest coverage of 4.5 is reasonably strong, which is a good sign. NanJing Pharmaceutical grew its EBIT by 3.4% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is NanJing Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, NanJing Pharmaceutical's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

NanJing Pharmaceutical's struggle handle its debt, based on its EBITDA, had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. We should also note that Healthcare industry companies like NanJing Pharmaceutical commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that NanJing Pharmaceutical is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 1 warning sign for NanJing Pharmaceutical that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.