Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Yantai Dongcheng Pharmaceutical Group Co.,Ltd. (SZSE:002675) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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 Yantai Dongcheng Pharmaceutical GroupLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Yantai Dongcheng Pharmaceutical GroupLtd had debt of CN¥933.0m, up from CN¥742.5m in one year. However, it also had CN¥842.4m in cash, and so its net debt is CN¥90.6m.

How Healthy Is Yantai Dongcheng Pharmaceutical GroupLtd's Balance Sheet?

We can see from the most recent balance sheet that Yantai Dongcheng Pharmaceutical GroupLtd had liabilities of CN¥1.89b falling due within a year, and liabilities of CN¥784.3m due beyond that. On the other hand, it had cash of CN¥842.4m and CN¥861.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥973.4m.

Of course, Yantai Dongcheng Pharmaceutical GroupLtd has a market capitalization of CN¥10.1b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Yantai Dongcheng Pharmaceutical GroupLtd has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Yantai Dongcheng Pharmaceutical GroupLtd has a low net debt to EBITDA ratio of only 0.20. And its EBIT covers its interest expense a whopping 10.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Yantai Dongcheng Pharmaceutical GroupLtd's saving grace is its low debt levels, because its EBIT has tanked 45% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Yantai Dongcheng Pharmaceutical GroupLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Yantai Dongcheng Pharmaceutical GroupLtd recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Based on what we've seen Yantai Dongcheng Pharmaceutical GroupLtd is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its net debt to EBITDA. When we consider all the factors mentioned above, we do feel a bit cautious about Yantai Dongcheng Pharmaceutical GroupLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Yantai Dongcheng Pharmaceutical GroupLtd you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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