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. As with many other companies Huadong Medicine Co., Ltd (SZSE:000963) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Huadong Medicine's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Huadong Medicine had CN¥2.28b of debt, an increase on CN¥1.54b, over one year. But on the other hand it also has CN¥4.74b in cash, leading to a CN¥2.46b net cash position.

A Look At Huadong Medicine's Liabilities

The latest balance sheet data shows that Huadong Medicine had liabilities of CN¥14.3b due within a year, and liabilities of CN¥591.8m falling due after that. On the other hand, it had cash of CN¥4.74b and CN¥11.1b worth of receivables due within a year. So it can boast CN¥916.4m more liquid assets than total liabilities.

Having regard to Huadong Medicine's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥58.1b company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, Huadong Medicine boasts net cash, so it's fair to say it does not have a heavy debt load!

Fortunately, Huadong Medicine grew its EBIT by 6.5% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Huadong Medicine'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Huadong Medicine has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Huadong Medicine produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Huadong Medicine has net cash of CN¥2.46b, as well as more liquid assets than liabilities. So we don't think Huadong Medicine's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Huadong Medicine is showing 1 warning sign in our investment analysis , you should know about...

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.