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. We note that Shanghai Yizhong Pharmaceutical Co., Ltd. (SHSE:688091) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Shanghai Yizhong Pharmaceutical Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Shanghai Yizhong Pharmaceutical had CN¥20.1m of debt, an increase on none, over one year. However, its balance sheet shows it holds CN¥1.13b in cash, so it actually has CN¥1.11b net cash.

How Healthy Is Shanghai Yizhong Pharmaceutical's Balance Sheet?

We can see from the most recent balance sheet that Shanghai Yizhong Pharmaceutical had liabilities of CN¥84.2m falling due within a year, and liabilities of CN¥4.86m due beyond that. Offsetting these obligations, it had cash of CN¥1.13b as well as receivables valued at CN¥141.1m due within 12 months. So it actually has CN¥1.18b more liquid assets than total liabilities.

This surplus suggests that Shanghai Yizhong Pharmaceutical is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Shanghai Yizhong Pharmaceutical has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, Shanghai Yizhong Pharmaceutical grew its EBIT by 95% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shanghai Yizhong Pharmaceutical will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Shanghai Yizhong Pharmaceutical 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. During the last two years, Shanghai Yizhong Pharmaceutical produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shanghai Yizhong Pharmaceutical has CN¥1.11b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 95% over the last year. So we don't think Shanghai Yizhong Pharmaceutical's use of debt is risky. 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 Shanghai Yizhong Pharmaceutical has 3 warning signs (and 1 which shouldn't be ignored) we think 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.

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.