Is C.Q. Pharmaceutical Holding (SZSE:000950) Using Too Much Debt?

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 C.Q. Pharmaceutical Holding Co., Ltd. (SZSE:000950) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for C.Q. Pharmaceutical Holding

What Is C.Q. Pharmaceutical Holding's Debt?

The chart below, which you can click on for greater detail, shows that C.Q. Pharmaceutical Holding had CN¥23.3b in debt in March 2024; about the same as the year before. However, it does have CN¥6.38b in cash offsetting this, leading to net debt of about CN¥16.9b.

A Look At C.Q. Pharmaceutical Holding's Liabilities

Zooming in on the latest balance sheet data, we can see that C.Q. Pharmaceutical Holding had liabilities of CN¥42.3b due within 12 months and liabilities of CN¥6.92b due beyond that. On the other hand, it had cash of CN¥6.38b and CN¥38.1b worth of receivables due within a year. So its liabilities total CN¥4.75b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since C.Q. Pharmaceutical Holding has a market capitalization of CN¥8.12b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

C.Q. Pharmaceutical Holding shareholders face the double whammy of a high net debt to EBITDA ratio (8.4), and fairly weak interest coverage, since EBIT is just 2.1 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, C.Q. Pharmaceutical Holding's EBIT was down 25% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine C.Q. Pharmaceutical Holding'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. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, C.Q. Pharmaceutical Holding 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.

Our View

On the face of it, C.Q. Pharmaceutical Holding's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. We should also note that Healthcare industry companies like C.Q. Pharmaceutical Holding commonly do use debt without problems. We're quite clear that we consider C.Q. Pharmaceutical Holding to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example C.Q. Pharmaceutical Holding has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com