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 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. Importantly, Heilongjiang ZBD Pharmaceutical Co., Ltd. (SHSE:603567) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Heilongjiang ZBD Pharmaceutical's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Heilongjiang ZBD Pharmaceutical had debt of CN¥3.48b, up from CN¥2.99b in one year. On the flip side, it has CN¥1.22b in cash leading to net debt of about CN¥2.25b.

How Strong Is Heilongjiang ZBD Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Heilongjiang ZBD Pharmaceutical had liabilities of CN¥3.12b due within 12 months and liabilities of CN¥1.48b due beyond that. Offsetting this, it had CN¥1.22b in cash and CN¥5.15b in receivables that were due within 12 months. So it can boast CN¥1.77b more liquid assets than total liabilities.

This surplus suggests that Heilongjiang ZBD Pharmaceutical is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Heilongjiang ZBD Pharmaceutical's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. We also note that Heilongjiang ZBD Pharmaceutical improved its EBIT from a last year's loss to a positive CN¥812m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Heilongjiang ZBD 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, 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. During the last year, Heilongjiang ZBD Pharmaceutical burned a lot of cash. 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

Heilongjiang ZBD Pharmaceutical's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Heilongjiang ZBD Pharmaceutical's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Heilongjiang ZBD Pharmaceutical (of which 1 makes us a bit uncomfortable!) you should know about.

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.