The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Tonghua Dongbao Pharmaceutical Co., Ltd. (SHSE:600867) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

What Is Tonghua Dongbao Pharmaceutical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Tonghua Dongbao Pharmaceutical had CN¥359.0m of debt, an increase on CN¥70.0m, over one year. But on the other hand it also has CN¥512.4m in cash, leading to a CN¥153.4m net cash position.

How Strong Is Tonghua Dongbao Pharmaceutical's Balance Sheet?

The latest balance sheet data shows that Tonghua Dongbao Pharmaceutical had liabilities of CN¥406.8m due within a year, and liabilities of CN¥141.5m falling due after that. Offsetting these obligations, it had cash of CN¥512.4m as well as receivables valued at CN¥614.8m due within 12 months. So it can boast CN¥578.9m more liquid assets than total liabilities.

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

In fact Tonghua Dongbao Pharmaceutical's saving grace is its low debt levels, because its EBIT has tanked 23% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Tonghua Dongbao 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Tonghua Dongbao Pharmaceutical 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. Looking at the most recent three years, Tonghua Dongbao Pharmaceutical recorded free cash flow of 32% 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 Tonghua Dongbao Pharmaceutical has CN¥153.4m in net cash and a decent-looking balance sheet. So we don't have any problem with Tonghua Dongbao Pharmaceutical's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Tonghua Dongbao Pharmaceutical has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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.