David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies ShuYu Civilian Pharmacy Corp., Ltd. (SZSE:301017) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is ShuYu Civilian Pharmacy's Debt?

As you can see below, at the end of September 2023, ShuYu Civilian Pharmacy had CN¥2.95b of debt, up from CN¥1.65b a year ago. Click the image for more detail. On the flip side, it has CN¥1.32b in cash leading to net debt of about CN¥1.63b.

How Healthy Is ShuYu Civilian Pharmacy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ShuYu Civilian Pharmacy had liabilities of CN¥4.56b due within 12 months and liabilities of CN¥1.87b due beyond that. On the other hand, it had cash of CN¥1.32b and CN¥1.25b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥3.86b.

This deficit is considerable relative to its market capitalization of CN¥5.73b, so it does suggest shareholders should keep an eye on ShuYu Civilian Pharmacy's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

ShuYu Civilian Pharmacy's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 4.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably, ShuYu Civilian Pharmacy's EBIT launched higher than Elon Musk, gaining a whopping 115% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since ShuYu Civilian Pharmacy will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, ShuYu Civilian Pharmacy reported free cash flow worth 13% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Neither ShuYu Civilian Pharmacy's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that ShuYu Civilian Pharmacy is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with ShuYu Civilian Pharmacy (at least 1 which is significant) , and understanding them should be part of your investment process.

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.