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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that China Resources Pharmaceutical Group Limited (HKG:3320) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is China Resources Pharmaceutical Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2024 China Resources Pharmaceutical Group had CN¥74.9b of debt, an increase on CN¥71.8b, over one year. On the flip side, it has CN¥33.1b in cash leading to net debt of about CN¥41.8b.
A Look At China Resources Pharmaceutical Group's Liabilities
According to the last reported balance sheet, China Resources Pharmaceutical Group had liabilities of CN¥144.0b due within 12 months, and liabilities of CN¥25.2b due beyond 12 months. Offsetting these obligations, it had cash of CN¥33.1b as well as receivables valued at CN¥114.5b due within 12 months. So it has liabilities totalling CN¥21.6b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of CN¥27.7b. 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.
With net debt to EBITDA of 3.0 China Resources Pharmaceutical Group has a fairly noticeable amount of debt. But the high interest coverage of 8.3 suggests it can easily service that debt. Notably China Resources Pharmaceutical Group's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Resources Pharmaceutical Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, China Resources Pharmaceutical Group generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Our View
When it comes to the balance sheet, the standout positive for China Resources Pharmaceutical Group was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about China Resources Pharmaceutical Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for China Resources Pharmaceutical Group that you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.