Is Shandong Lukang PharmaceuticalLtd (SHSE:600789) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Shandong Lukang Pharmaceutical Co.,Ltd. (SHSE:600789) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shandong Lukang PharmaceuticalLtd

How Much Debt Does Shandong Lukang PharmaceuticalLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shandong Lukang PharmaceuticalLtd had CN¥2.83b of debt, an increase on CN¥2.56b, over one year. However, it also had CN¥900.4m in cash, and so its net debt is CN¥1.93b.

How Healthy Is Shandong Lukang PharmaceuticalLtd's Balance Sheet?

We can see from the most recent balance sheet that Shandong Lukang PharmaceuticalLtd had liabilities of CN¥3.47b falling due within a year, and liabilities of CN¥1.63b due beyond that. Offsetting this, it had CN¥900.4m in cash and CN¥1.51b in receivables that were due within 12 months. So its liabilities total CN¥2.69b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shandong Lukang PharmaceuticalLtd has a market capitalization of CN¥6.98b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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.

Shandong Lukang PharmaceuticalLtd's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, Shandong Lukang PharmaceuticalLtd grew its EBIT by 21% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Shandong Lukang PharmaceuticalLtd recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Shandong Lukang PharmaceuticalLtd's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its interest cover makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Shandong Lukang PharmaceuticalLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For example - Shandong Lukang PharmaceuticalLtd has 3 warning signs we think you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.