Is Shanghai Pharmaceuticals Holding (SHSE:601607) A Risky Investment?

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 can see that Shanghai Pharmaceuticals Holding Co., Ltd (SHSE:601607) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

See our latest analysis for Shanghai Pharmaceuticals Holding

What Is Shanghai Pharmaceuticals Holding's Debt?

The image below, which you can click on for greater detail, shows that Shanghai Pharmaceuticals Holding had debt of CN¥48.4b at the end of September 2024, a reduction from CN¥51.7b over a year. However, it also had CN¥42.4b in cash, and so its net debt is CN¥6.04b.

How Healthy Is Shanghai Pharmaceuticals Holding's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Pharmaceuticals Holding had liabilities of CN¥129.5b due within 12 months and liabilities of CN¥11.1b due beyond that. On the other hand, it had cash of CN¥42.4b and CN¥89.2b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.96b.

Of course, Shanghai Pharmaceuticals Holding has a market capitalization of CN¥71.6b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Pharmaceuticals Holding has a low debt to EBITDA ratio of only 0.62. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. But the other side of the story is that Shanghai Pharmaceuticals Holding saw its EBIT decline by 6.1% 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 ultimately the future profitability of the business will decide if Shanghai Pharmaceuticals Holding can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shanghai Pharmaceuticals Holding reported free cash flow worth 20% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis Shanghai Pharmaceuticals Holding's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. It's also worth noting that Shanghai Pharmaceuticals Holding is in the Healthcare industry, which is often considered to be quite defensive. Considering this range of data points, we think Shanghai Pharmaceuticals Holding is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Shanghai Pharmaceuticals Holding .

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.