Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Guangdong Zhongsheng Pharmaceutical Co., Ltd. (SZSE:002317) does use debt in its business. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Guangdong Zhongsheng Pharmaceutical Carry?

The image below, which you can click on for greater detail, shows that Guangdong Zhongsheng Pharmaceutical had debt of CN¥429.4m at the end of March 2024, a reduction from CN¥594.3m over a year. But on the other hand it also has CN¥1.64b in cash, leading to a CN¥1.21b net cash position.

How Healthy Is Guangdong Zhongsheng Pharmaceutical's Balance Sheet?

The latest balance sheet data shows that Guangdong Zhongsheng Pharmaceutical had liabilities of CN¥826.0m due within a year, and liabilities of CN¥821.2m falling due after that. On the other hand, it had cash of CN¥1.64b and CN¥1.23b worth of receivables due within a year. So it actually has CN¥1.22b more liquid assets than total liabilities.

This short term liquidity is a sign that Guangdong Zhongsheng Pharmaceutical could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Guangdong Zhongsheng Pharmaceutical has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Guangdong Zhongsheng Pharmaceutical's saving grace is its low debt levels, because its EBIT has tanked 24% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Guangdong Zhongsheng 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Guangdong Zhongsheng 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. Considering the last three years, Guangdong Zhongsheng Pharmaceutical actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Guangdong Zhongsheng Pharmaceutical has net cash of CN¥1.21b, as well as more liquid assets than liabilities. So we don't have any problem with Guangdong Zhongsheng Pharmaceutical's use of debt. 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. To that end, you should learn about the 3 warning signs we've spotted with Guangdong Zhongsheng Pharmaceutical (including 1 which can't be ignored) .

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