Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Tianjin Tianyao Pharmaceuticals Co., Ltd. (SHSE:600488) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Tianjin Tianyao Pharmaceuticals's Net Debt?

As you can see below, Tianjin Tianyao Pharmaceuticals had CN¥922.3m of debt at March 2024, down from CN¥1.28b a year prior. However, because it has a cash reserve of CN¥721.0m, its net debt is less, at about CN¥201.4m.

A Look At Tianjin Tianyao Pharmaceuticals' Liabilities

According to the last reported balance sheet, Tianjin Tianyao Pharmaceuticals had liabilities of CN¥1.83b due within 12 months, and liabilities of CN¥465.5m due beyond 12 months. On the other hand, it had cash of CN¥721.0m and CN¥625.3m worth of receivables due within a year. So its liabilities total CN¥948.6m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Tianjin Tianyao Pharmaceuticals has a market capitalization of CN¥3.95b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Tianjin Tianyao Pharmaceuticals's low debt to EBITDA ratio of 0.49 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.5 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. The modesty of its debt load may become crucial for Tianjin Tianyao Pharmaceuticals if management cannot prevent a repeat of the 47% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Tianjin Tianyao Pharmaceuticals will need earnings to service that debt. 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.

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, Tianjin Tianyao Pharmaceuticals actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Based on what we've seen Tianjin Tianyao Pharmaceuticals is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. Considering this range of data points, we think Tianjin Tianyao Pharmaceuticals is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Tianjin Tianyao Pharmaceuticals is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.