Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 GuangYuYuan Chinese Herbal Medicine Co., Ltd. (SHSE:600771) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is GuangYuYuan Chinese Herbal Medicine's Debt?

As you can see below, GuangYuYuan Chinese Herbal Medicine had CN¥251.9m of debt at March 2024, down from CN¥410.8m a year prior. However, its balance sheet shows it holds CN¥385.2m in cash, so it actually has CN¥133.3m net cash.

How Healthy Is GuangYuYuan Chinese Herbal Medicine's Balance Sheet?

We can see from the most recent balance sheet that GuangYuYuan Chinese Herbal Medicine had liabilities of CN¥968.5m falling due within a year, and liabilities of CN¥79.7m due beyond that. On the other hand, it had cash of CN¥385.2m and CN¥716.7m worth of receivables due within a year. So it actually has CN¥53.8m more liquid assets than total liabilities.

This state of affairs indicates that GuangYuYuan Chinese Herbal Medicine's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥9.59b company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, GuangYuYuan Chinese Herbal Medicine boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, GuangYuYuan Chinese Herbal Medicine turned things around in the last 12 months, delivering and EBIT of CN¥139m. 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 GuangYuYuan Chinese Herbal Medicine 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. GuangYuYuan Chinese Herbal Medicine may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, GuangYuYuan Chinese Herbal Medicine actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While it is always sensible to investigate a company's debt, in this case GuangYuYuan Chinese Herbal Medicine has CN¥133.3m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥207m, being 148% of its EBIT. So we don't think GuangYuYuan Chinese Herbal Medicine's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - GuangYuYuan Chinese Herbal Medicine has 1 warning sign we think you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com