David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Cathay Biotech Inc. (SHSE:688065) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Cathay Biotech's Debt?

As you can see below, Cathay Biotech had CN¥1.31b of debt at June 2024, down from CN¥1.46b a year prior. But on the other hand it also has CN¥4.64b in cash, leading to a CN¥3.32b net cash position.

How Strong Is Cathay Biotech's Balance Sheet?

We can see from the most recent balance sheet that Cathay Biotech had liabilities of CN¥2.45b falling due within a year, and liabilities of CN¥977.7m due beyond that. On the other hand, it had cash of CN¥4.64b and CN¥504.3m worth of receivables due within a year. So it actually has CN¥1.71b more liquid assets than total liabilities.

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

But the other side of the story is that Cathay Biotech saw its EBIT decline by 8.9% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Cathay Biotech 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 Cathay Biotech 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. During the last three years, Cathay Biotech burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Cathay Biotech has net cash of CN¥3.32b, as well as more liquid assets than liabilities. So we are not troubled with Cathay Biotech's debt use. 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. We've identified 2 warning signs with Cathay Biotech (at least 1 which is concerning) , and understanding them should be part of your investment process.

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.