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 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. We note that Yifeng Pharmacy Chain Co., Ltd. (SHSE:603939) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is Yifeng Pharmacy Chain's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Yifeng Pharmacy Chain had debt of CN¥3.22b, up from CN¥1.60b in one year. But on the other hand it also has CN¥6.98b in cash, leading to a CN¥3.76b net cash position.

A Look At Yifeng Pharmacy Chain's Liabilities

We can see from the most recent balance sheet that Yifeng Pharmacy Chain had liabilities of CN¥11.1b falling due within a year, and liabilities of CN¥4.01b due beyond that. On the other hand, it had cash of CN¥6.98b and CN¥2.86b worth of receivables due within a year. So it has liabilities totalling CN¥5.26b more than its cash and near-term receivables, combined.

Of course, Yifeng Pharmacy Chain has a market capitalization of CN¥29.8b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Yifeng Pharmacy Chain boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that Yifeng Pharmacy Chain has increased its EBIT by 4.6% over twelve months, which should ease any concerns about debt repayment. 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 Yifeng Pharmacy Chain 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. Yifeng Pharmacy Chain may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Yifeng Pharmacy Chain actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Yifeng Pharmacy Chain does have more liabilities than liquid assets, it also has net cash of CN¥3.76b. The cherry on top was that in converted 155% of that EBIT to free cash flow, bringing in CN¥3.2b. So we don't think Yifeng Pharmacy Chain's use of debt is risky. 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 1 warning sign for Yifeng Pharmacy Chain you should know about.

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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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com