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. Importantly, ShuYu Civilian Pharmacy Corp., Ltd. (SZSE:301017) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does ShuYu Civilian Pharmacy Carry?

As you can see below, at the end of March 2024, ShuYu Civilian Pharmacy had CN¥3.60b of debt, up from CN¥2.47b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.58b, its net debt is less, at about CN¥2.01b.

How Strong Is ShuYu Civilian Pharmacy's Balance Sheet?

We can see from the most recent balance sheet that ShuYu Civilian Pharmacy had liabilities of CN¥5.35b falling due within a year, and liabilities of CN¥1.85b due beyond that. Offsetting this, it had CN¥1.58b in cash and CN¥1.46b in receivables that were due within 12 months. So its liabilities total CN¥4.16b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥4.28b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 6.7 hit our confidence in ShuYu Civilian Pharmacy like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, ShuYu Civilian Pharmacy's EBIT was down 42% over the last year. 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is ShuYu Civilian Pharmacy's earnings that will influence how the balance sheet holds up in the future. 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, ShuYu Civilian Pharmacy created free cash flow amounting to 8.1% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, ShuYu Civilian Pharmacy's net debt to EBITDA 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. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like ShuYu Civilian Pharmacy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 ShuYu Civilian Pharmacy is showing 3 warning signs in our investment analysis , and 1 of those is significant...

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