Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Guizhou Xinbang Pharmaceutical Co., Ltd. (SZSE:002390) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Guizhou Xinbang Pharmaceutical's Net Debt?

As you can see below, Guizhou Xinbang Pharmaceutical had CN¥819.8m of debt at June 2024, down from CN¥1.33b a year prior. However, because it has a cash reserve of CN¥730.0m, its net debt is less, at about CN¥89.9m.

A Look At Guizhou Xinbang Pharmaceutical's Liabilities

According to the last reported balance sheet, Guizhou Xinbang Pharmaceutical had liabilities of CN¥1.88b due within 12 months, and liabilities of CN¥42.2m due beyond 12 months. On the other hand, it had cash of CN¥730.0m and CN¥3.33b worth of receivables due within a year. So it can boast CN¥2.14b more liquid assets than total liabilities.

This surplus strongly suggests that Guizhou Xinbang Pharmaceutical has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is as strong as an ox. Carrying virtually no net debt, Guizhou Xinbang Pharmaceutical has a very light debt load indeed.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Guizhou Xinbang Pharmaceutical's net debt is only 0.16 times its EBITDA. And its EBIT easily covers its interest expense, being 31.6 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Guizhou Xinbang Pharmaceutical saw its EBIT decline by 8.3% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Guizhou Xinbang Pharmaceutical'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Guizhou Xinbang Pharmaceutical actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Guizhou Xinbang Pharmaceutical's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Considering this range of factors, it seems to us that Guizhou Xinbang Pharmaceutical is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. 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 example - Guizhou Xinbang Pharmaceutical has 1 warning sign we think you should be aware of.

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.