ShuYu Civilian Pharmacy (SZSE:301017) Seems To Be Using A Lot Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 ShuYu Civilian Pharmacy Corp., Ltd. (SZSE:301017) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for ShuYu Civilian Pharmacy

What Is ShuYu Civilian Pharmacy's Net Debt?

As you can see below, at the end of June 2024, ShuYu Civilian Pharmacy had CN¥3.23b of debt, up from CN¥2.24b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.30b, its net debt is less, at about CN¥1.92b.

A Look At ShuYu Civilian Pharmacy's Liabilities

We can see from the most recent balance sheet that ShuYu Civilian Pharmacy had liabilities of CN¥4.92b falling due within a year, and liabilities of CN¥1.86b due beyond that. Offsetting these obligations, it had cash of CN¥1.30b as well as receivables valued at CN¥1.45b due within 12 months. So it has liabilities totalling CN¥4.02b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥5.01b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 8.8 hit our confidence in ShuYu Civilian Pharmacy like a one-two punch to the gut. The debt burden here is substantial. Even worse, ShuYu Civilian Pharmacy saw its EBIT tank 66% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is ShuYu Civilian Pharmacy'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, ShuYu Civilian Pharmacy actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both ShuYu Civilian Pharmacy's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its conversion of EBIT to free cash flow fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like ShuYu Civilian Pharmacy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example ShuYu Civilian Pharmacy has 4 warning signs (and 3 which are potentially serious) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.