Does Shandong Lukang PharmaceuticalLtd (SHSE:600789) Have A Healthy Balance Sheet?

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.' 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. As with many other companies Shandong Lukang Pharmaceutical Co.,Ltd. (SHSE:600789) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Shandong Lukang PharmaceuticalLtd

What Is Shandong Lukang PharmaceuticalLtd's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Shandong Lukang PharmaceuticalLtd had debt of CN¥2.75b, up from CN¥2.58b in one year. However, because it has a cash reserve of CN¥788.8m, its net debt is less, at about CN¥1.96b.

A Look At Shandong Lukang PharmaceuticalLtd's Liabilities

According to the last reported balance sheet, Shandong Lukang PharmaceuticalLtd had liabilities of CN¥3.25b due within 12 months, and liabilities of CN¥1.60b due beyond 12 months. On the other hand, it had cash of CN¥788.8m and CN¥1.80b worth of receivables due within a year. So it has liabilities totalling CN¥2.26b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Shandong Lukang PharmaceuticalLtd is worth CN¥6.35b, and thus could probably raise enough capital to shore up 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.

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.

Shandong Lukang PharmaceuticalLtd's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 3.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Shandong Lukang PharmaceuticalLtd improved its EBIT by 7.8% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shandong Lukang PharmaceuticalLtd's earnings that will influence how the balance sheet holds up in the future. 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 always check how much of that EBIT is translated into free cash flow. In the last three years, Shandong Lukang PharmaceuticalLtd's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Shandong Lukang PharmaceuticalLtd's interest cover and its conversion of EBIT to free cash flow were discouraging. At least its EBIT growth rate gives us reason to be optimistic. Looking at all the angles mentioned above, it does seem to us that Shandong Lukang PharmaceuticalLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. We've identified 3 warning signs with Shandong Lukang PharmaceuticalLtd (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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.