Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Hunan Er-Kang Pharmaceutical Co., Ltd (SZSE:300267) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

How Much Debt Does Hunan Er-Kang Pharmaceutical Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Hunan Er-Kang Pharmaceutical had debt of CN¥399.4m, up from CN¥149.0m in one year. However, it does have CN¥768.4m in cash offsetting this, leading to net cash of CN¥369.0m.

How Strong Is Hunan Er-Kang Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hunan Er-Kang Pharmaceutical had liabilities of CN¥626.9m due within 12 months and liabilities of CN¥68.8m due beyond that. Offsetting this, it had CN¥768.4m in cash and CN¥183.9m in receivables that were due within 12 months. So it can boast CN¥256.5m more liquid assets than total liabilities.

This surplus suggests that Hunan Er-Kang Pharmaceutical has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Hunan Er-Kang Pharmaceutical boasts net cash, so it's fair to say it does not have a heavy debt load! The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hunan Er-Kang Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Over 12 months, Hunan Er-Kang Pharmaceutical made a loss at the EBIT level, and saw its revenue drop to CN¥1.2b, which is a fall of 40%. To be frank that doesn't bode well.

So How Risky Is Hunan Er-Kang Pharmaceutical?

While Hunan Er-Kang Pharmaceutical lost money on an earnings before interest and tax (EBIT) level, it actually generated positive free cash flow CN¥22m. So although it is loss-making, it doesn't seem to have too much near-term balance sheet risk, keeping in mind the net cash. We'll feel more comfortable with the stock once EBIT is positive, given the lacklustre revenue growth. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Hunan Er-Kang Pharmaceutical 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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