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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Shanghai Yizhong Pharmaceutical Co., Ltd. (SHSE:688091) makes use of debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shanghai Yizhong Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Shanghai Yizhong Pharmaceutical had debt of CN¥31.0m, up from CN¥20.1m in one year. But it also has CN¥733.5m in cash to offset that, meaning it has CN¥702.5m net cash.

A Look At Shanghai Yizhong Pharmaceutical's Liabilities

According to the last reported balance sheet, Shanghai Yizhong Pharmaceutical had liabilities of CN¥71.3m due within 12 months, and liabilities of CN¥4.22m due beyond 12 months. On the other hand, it had cash of CN¥733.5m and CN¥139.0m worth of receivables due within a year. So it actually has CN¥797.0m more liquid assets than total liabilities.

This surplus suggests that Shanghai Yizhong Pharmaceutical has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Shanghai Yizhong Pharmaceutical boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Shanghai Yizhong Pharmaceutical if management cannot prevent a repeat of the 53% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shanghai Yizhong Pharmaceutical will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Shanghai Yizhong 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. Looking at the most recent three years, Shanghai Yizhong Pharmaceutical recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Shanghai Yizhong Pharmaceutical has CN¥702.5m in net cash and a decent-looking balance sheet. So we are not troubled with Shanghai Yizhong Pharmaceutical's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Shanghai Yizhong Pharmaceutical that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.