Here's Why Zhejiang Huahai Pharmaceutical (SHSE:600521) Has A Meaningful Debt Burden

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Zhejiang Huahai Pharmaceutical Co., Ltd. (SHSE:600521) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Zhejiang Huahai Pharmaceutical

What Is Zhejiang Huahai Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that Zhejiang Huahai Pharmaceutical had debt of CN¥6.85b at the end of June 2024, a reduction from CN¥7.63b over a year. On the flip side, it has CN¥1.66b in cash leading to net debt of about CN¥5.19b.

A Look At Zhejiang Huahai Pharmaceutical's Liabilities

The latest balance sheet data shows that Zhejiang Huahai Pharmaceutical had liabilities of CN¥5.71b due within a year, and liabilities of CN¥4.84b falling due after that. On the other hand, it had cash of CN¥1.66b and CN¥2.98b worth of receivables due within a year. So it has liabilities totalling CN¥5.92b more than its cash and near-term receivables, combined.

Zhejiang Huahai Pharmaceutical has a market capitalization of CN¥23.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

With a debt to EBITDA ratio of 2.2, Zhejiang Huahai Pharmaceutical uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.5 times its interest expenses harmonizes with that theme. Unfortunately, Zhejiang Huahai Pharmaceutical saw its EBIT slide 3.7% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhejiang Huahai Pharmaceutical'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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhejiang Huahai Pharmaceutical saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Zhejiang Huahai Pharmaceutical's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its interest cover was re-invigorating. When we consider all the factors discussed, it seems to us that Zhejiang Huahai Pharmaceutical is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 - Zhejiang Huahai Pharmaceutical has 2 warning signs we think you should be aware of.

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.