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.' 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 Shandong Buchang Pharmaceuticals Co., Ltd. (SHSE:603858) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Shandong Buchang Pharmaceuticals's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shandong Buchang Pharmaceuticals had CN¥3.80b of debt, an increase on CN¥3.21b, over one year. On the flip side, it has CN¥1.61b in cash leading to net debt of about CN¥2.19b.

A Look At Shandong Buchang Pharmaceuticals' Liabilities

Zooming in on the latest balance sheet data, we can see that Shandong Buchang Pharmaceuticals had liabilities of CN¥6.34b due within 12 months and liabilities of CN¥3.39b due beyond that. Offsetting these obligations, it had cash of CN¥1.61b as well as receivables valued at CN¥1.44b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.67b.

This deficit isn't so bad because Shandong Buchang Pharmaceuticals is worth CN¥15.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shandong Buchang Pharmaceuticals has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.4 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that Shandong Buchang Pharmaceuticals's EBIT was down 63% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong Buchang Pharmaceuticals'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shandong Buchang Pharmaceuticals produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Shandong Buchang Pharmaceuticals's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to convert EBIT to free cash flow isn't too shabby at all. When we consider all the factors discussed, it seems to us that Shandong Buchang Pharmaceuticals is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Shandong Buchang Pharmaceuticals you should be aware of.

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.