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.' 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 note that Zhejiang Huakang Pharmaceutical Co., Ltd. (SHSE:605077) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Zhejiang Huakang Pharmaceutical

How Much Debt Does Zhejiang Huakang Pharmaceutical Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Zhejiang Huakang Pharmaceutical had CN¥1.23b of debt, an increase on CN¥533.4m, over one year. However, because it has a cash reserve of CN¥909.2m, its net debt is less, at about CN¥323.4m.

A Look At Zhejiang Huakang Pharmaceutical's Liabilities

The latest balance sheet data shows that Zhejiang Huakang Pharmaceutical had liabilities of CN¥856.0m due within a year, and liabilities of CN¥1.04b falling due after that. On the other hand, it had cash of CN¥909.2m and CN¥448.8m worth of receivables due within a year. So it has liabilities totalling CN¥536.4m more than its cash and near-term receivables, combined.

Since publicly traded Zhejiang Huakang Pharmaceutical shares are worth a total of CN¥4.24b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zhejiang Huakang Pharmaceutical has a low net debt to EBITDA ratio of only 0.64. And its EBIT easily covers its interest expense, being 18.9 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Zhejiang Huakang Pharmaceutical grew its EBIT by 71% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zhejiang Huakang 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.

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, Zhejiang Huakang Pharmaceutical saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Happily, Zhejiang Huakang Pharmaceutical's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Zhejiang Huakang Pharmaceutical can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zhejiang Huakang Pharmaceutical is showing 2 warning signs in our investment analysis , you should know about...

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.