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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, China Resources Pharmaceutical Group Limited (HKG:3320) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is China Resources Pharmaceutical Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 China Resources Pharmaceutical Group had debt of CN¥74.9b, up from CN¥71.8b in one year. However, it does have CN¥33.1b in cash offsetting this, leading to net debt of about CN¥41.8b.

A Look At China Resources Pharmaceutical Group's Liabilities

Zooming in on the latest balance sheet data, we can see that China Resources Pharmaceutical Group had liabilities of CN¥144.0b due within 12 months and liabilities of CN¥25.2b due beyond that. On the other hand, it had cash of CN¥33.1b and CN¥114.5b worth of receivables due within a year. So it has liabilities totalling CN¥21.7b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥32.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

With net debt to EBITDA of 2.9 China Resources Pharmaceutical Group has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.3 times its interest expense, and its net debt to EBITDA, was quite high, at 2.9. If China Resources Pharmaceutical Group can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Resources Pharmaceutical Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China Resources Pharmaceutical Group recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

On our analysis China Resources Pharmaceutical Group's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the elements mentioned above, it seems to us that China Resources Pharmaceutical Group is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 1 warning sign for China Resources Pharmaceutical Group that you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.