Zhejiang Huahai Pharmaceutical (SHSE:600521) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Zhejiang Huahai Pharmaceutical Co., Ltd. (SHSE:600521) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Zhejiang Huahai Pharmaceutical

What Is Zhejiang Huahai Pharmaceutical's Debt?

As you can see below, at the end of March 2024, Zhejiang Huahai Pharmaceutical had CN¥8.17b of debt, up from CN¥7.47b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥2.90b, its net debt is less, at about CN¥5.27b.

How Strong Is Zhejiang Huahai Pharmaceutical's Balance Sheet?

According to the last reported balance sheet, Zhejiang Huahai Pharmaceutical had liabilities of CN¥6.70b due within 12 months, and liabilities of CN¥4.90b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.90b as well as receivables valued at CN¥2.56b due within 12 months. So it has liabilities totalling CN¥6.14b more than its cash and near-term receivables, combined.

Zhejiang Huahai Pharmaceutical has a market capitalization of CN¥25.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Zhejiang Huahai Pharmaceutical's net debt of 2.3 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.8 times interest expense) certainly does not do anything to dispel this impression. The bad news is that Zhejiang Huahai Pharmaceutical saw its EBIT decline by 12% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Zhejiang Huahai Pharmaceutical can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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

Mulling over Zhejiang Huahai Pharmaceutical's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Zhejiang Huahai Pharmaceutical's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Be aware that Zhejiang Huahai Pharmaceutical is showing 2 warning signs in our investment analysis , 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.