Here's Why Lepu Medical Technology (Beijing) (SZSE:300003) Can Manage Its Debt Responsibly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Lepu Medical Technology (Beijing) Co., Ltd. (SZSE:300003) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Lepu Medical Technology (Beijing)

What Is Lepu Medical Technology (Beijing)'s Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Lepu Medical Technology (Beijing) had debt of CN¥5.52b, up from CN¥4.58b in one year. However, it also had CN¥3.75b in cash, and so its net debt is CN¥1.76b.

How Strong Is Lepu Medical Technology (Beijing)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Lepu Medical Technology (Beijing) had liabilities of CN¥2.63b due within 12 months and liabilities of CN¥5.08b due beyond that. On the other hand, it had cash of CN¥3.75b and CN¥2.25b worth of receivables due within a year. So it has liabilities totalling CN¥1.70b more than its cash and near-term receivables, combined.

Given Lepu Medical Technology (Beijing) has a market capitalization of CN¥22.6b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Lepu Medical Technology (Beijing) has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 15.0 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Lepu Medical Technology (Beijing)'s load is not too heavy, because its EBIT was down 55% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lepu Medical Technology (Beijing)'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Lepu Medical Technology (Beijing) recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Based on what we've seen Lepu Medical Technology (Beijing) is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. It's also worth noting that Lepu Medical Technology (Beijing) is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Lepu Medical Technology (Beijing)'s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. We've identified 3 warning signs with Lepu Medical Technology (Beijing) (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.