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. We note that Simcere Pharmaceutical Group Limited (HKG:2096) does have debt on its balance sheet. But is this debt a concern to shareholders?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Simcere Pharmaceutical Group's Debt?
The image below, which you can click on for greater detail, shows that at June 2024 Simcere Pharmaceutical Group had debt of CN¥1.00b, up from CN¥909.6m in one year. However, it does have CN¥3.06b in cash offsetting this, leading to net cash of CN¥2.05b.
A Look At Simcere Pharmaceutical Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Simcere Pharmaceutical Group had liabilities of CN¥3.06b due within 12 months and liabilities of CN¥1.75b due beyond that. Offsetting these obligations, it had cash of CN¥3.06b as well as receivables valued at CN¥2.42b due within 12 months. So it can boast CN¥669.0m more liquid assets than total liabilities.
This short term liquidity is a sign that Simcere Pharmaceutical Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Simcere Pharmaceutical Group boasts net cash, so it's fair to say it does not have a heavy debt load!
On top of that, Simcere Pharmaceutical Group grew its EBIT by 59% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Simcere Pharmaceutical Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Simcere Pharmaceutical Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Considering the last three years, Simcere Pharmaceutical Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Simcere Pharmaceutical Group has net cash of CN¥2.05b, as well as more liquid assets than liabilities. And we liked the look of last year's 59% year-on-year EBIT growth. So we are not troubled with Simcere Pharmaceutical Group's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Simcere Pharmaceutical Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
