The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, Shenzhen Neptunus Bioengineering Co., Ltd. (SZSE:000078) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shenzhen Neptunus Bioengineering's Debt?

As you can see below, Shenzhen Neptunus Bioengineering had CN¥11.2b of debt at March 2024, down from CN¥12.2b a year prior. On the flip side, it has CN¥3.93b in cash leading to net debt of about CN¥7.32b.

How Healthy Is Shenzhen Neptunus Bioengineering's Balance Sheet?

The latest balance sheet data shows that Shenzhen Neptunus Bioengineering had liabilities of CN¥28.0b due within a year, and liabilities of CN¥392.7m falling due after that. On the other hand, it had cash of CN¥3.93b and CN¥20.8b worth of receivables due within a year. So its liabilities total CN¥3.72b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥6.05b, so it does suggest shareholders should keep an eye on Shenzhen Neptunus Bioengineering's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.67 times and a disturbingly high net debt to EBITDA ratio of 9.1 hit our confidence in Shenzhen Neptunus Bioengineering like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that Shenzhen Neptunus Bioengineering saw its EBIT drop by 20% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Shenzhen Neptunus Bioengineering will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Shenzhen Neptunus Bioengineering actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Shenzhen Neptunus Bioengineering's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. And even its conversion of EBIT to free cash flow fails to inspire much confidence. We should also note that Healthcare industry companies like Shenzhen Neptunus Bioengineering commonly do use debt without problems. Taking into account all the aforementioned factors, it looks like Shenzhen Neptunus Bioengineering has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Shenzhen Neptunus Bioengineering , and understanding them should be part of your investment process.

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.