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 can see that Shenzhen Neptunus Bioengineering Co., Ltd. (SZSE:000078) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

What Is Shenzhen Neptunus Bioengineering's Net Debt?

As you can see below, Shenzhen Neptunus Bioengineering had CN¥12.0b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥3.18b in cash, and so its net debt is CN¥8.86b.

How Strong Is Shenzhen Neptunus Bioengineering's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Neptunus Bioengineering had liabilities of CN¥29.5b falling due within a year, and liabilities of CN¥374.3m due beyond that. On the other hand, it had cash of CN¥3.18b and CN¥23.5b worth of receivables due within a year. So it has liabilities totalling CN¥3.12b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Shenzhen Neptunus Bioengineering has a market capitalization of CN¥6.46b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Weak interest cover of 0.88 times and a disturbingly high net debt to EBITDA ratio of 8.9 hit our confidence in Shenzhen Neptunus Bioengineering like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Shenzhen Neptunus Bioengineering saw its EBIT tank 23% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shenzhen Neptunus Bioengineering'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Shenzhen Neptunus Bioengineering recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Shenzhen Neptunus Bioengineering's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We should also note that Healthcare industry companies like Shenzhen Neptunus Bioengineering commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Shenzhen Neptunus Bioengineering's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Shenzhen Neptunus Bioengineering , and understanding them should be part of your investment process.

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.