We Think Huapont Life SciencesLtd (SZSE:002004) Is Taking Some Risk With Its Debt

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.' 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. We note that Huapont Life Sciences Co.,Ltd. (SZSE:002004) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. 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.

See our latest analysis for Huapont Life SciencesLtd

What Is Huapont Life SciencesLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Huapont Life SciencesLtd had CN¥9.34b of debt, an increase on CN¥8.29b, over one year. However, it also had CN¥4.24b in cash, and so its net debt is CN¥5.10b.

A Look At Huapont Life SciencesLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Huapont Life SciencesLtd had liabilities of CN¥10.6b due within 12 months and liabilities of CN¥4.02b due beyond that. On the other hand, it had cash of CN¥4.24b and CN¥3.56b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.81b.

This deficit is considerable relative to its market capitalization of CN¥9.00b, so it does suggest shareholders should keep an eye on Huapont Life SciencesLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Huapont Life SciencesLtd has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that Huapont Life SciencesLtd's EBIT was down 28% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Huapont Life SciencesLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Huapont Life SciencesLtd recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Huapont Life SciencesLtd's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. We're quite clear that we consider Huapont Life SciencesLtd 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Huapont Life SciencesLtd (2 don't sit too well with us!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.