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 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. Importantly, Huadong Medicine Co., Ltd (SZSE:000963) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Huadong Medicine's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Huadong Medicine had debt of CN¥1.60b, up from CN¥1.38b in one year. However, it does have CN¥3.56b in cash offsetting this, leading to net cash of CN¥1.96b.

A Look At Huadong Medicine's Liabilities

Zooming in on the latest balance sheet data, we can see that Huadong Medicine had liabilities of CN¥10.9b due within 12 months and liabilities of CN¥1.06b due beyond that. Offsetting these obligations, it had cash of CN¥3.56b as well as receivables valued at CN¥11.0b due within 12 months. So it actually has CN¥2.58b more liquid assets than total liabilities.

This surplus suggests that Huadong Medicine has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Huadong Medicine has more cash than debt is arguably a good indication that it can manage its debt safely.

And we also note warmly that Huadong Medicine grew its EBIT by 11% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Huadong Medicine 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 company can only pay off debt with cold hard cash, not accounting profits. Huadong 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 most recent three years, Huadong Medicine recorded free cash flow worth 51% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Huadong Medicine has CN¥1.96b in net cash and a decent-looking balance sheet. On top of that, it increased its EBIT by 11% in the last twelve months. So we don't think Huadong 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. Case in point: We've spotted 1 warning sign for Huadong Medicine you should be aware of.

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