Warren Buffett famously said, '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. We can see that Zhejiang Tianyu Pharmaceutical Co., Ltd. (SZSE:300702) does use debt in its business. But the more important question is: how much risk is that debt creating?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Zhejiang Tianyu Pharmaceutical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Zhejiang Tianyu Pharmaceutical had CN¥1.69b of debt, an increase on CN¥1.58b, over one year. However, because it has a cash reserve of CN¥357.3m, its net debt is less, at about CN¥1.33b.

A Look At Zhejiang Tianyu Pharmaceutical's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhejiang Tianyu Pharmaceutical had liabilities of CN¥2.39b due within 12 months and liabilities of CN¥285.7m due beyond that. Offsetting this, it had CN¥357.3m in cash and CN¥574.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.74b.

While this might seem like a lot, it is not so bad since Zhejiang Tianyu Pharmaceutical has a market capitalization of CN¥5.89b, 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Zhejiang Tianyu Pharmaceutical has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 2.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One redeeming factor for Zhejiang Tianyu Pharmaceutical is that it turned last year's EBIT loss into a gain of CN¥92m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Zhejiang Tianyu Pharmaceutical can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Zhejiang Tianyu Pharmaceutical saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We'd go so far as to say Zhejiang Tianyu Pharmaceutical's conversion of EBIT to free cash flow was disappointing. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that Zhejiang Tianyu Pharmaceutical's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Even though Zhejiang Tianyu Pharmaceutical lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.

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