Is North China Pharmaceutical Company.Ltd (SHSE:600812) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, North China Pharmaceutical Company.Ltd (SHSE:600812) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for North China Pharmaceutical Company.Ltd

How Much Debt Does North China Pharmaceutical Company.Ltd Carry?

As you can see below, North China Pharmaceutical Company.Ltd had CN¥11.4b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥1.72b in cash leading to net debt of about CN¥9.67b.

How Healthy Is North China Pharmaceutical Company.Ltd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that North China Pharmaceutical Company.Ltd had liabilities of CN¥11.1b due within 12 months and liabilities of CN¥4.02b due beyond that. Offsetting these obligations, it had cash of CN¥1.72b as well as receivables valued at CN¥4.08b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.30b.

When you consider that this deficiency exceeds the company's CN¥9.08b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

North China Pharmaceutical Company.Ltd shareholders face the double whammy of a high net debt to EBITDA ratio (7.2), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. This means we'd consider it to have a heavy debt load. The good news is that North China Pharmaceutical Company.Ltd improved its EBIT by 5.5% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since North China Pharmaceutical Company.Ltd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Over the last three years, North China Pharmaceutical Company.Ltd recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

North China Pharmaceutical Company.Ltd's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that North China Pharmaceutical Company.Ltd 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. 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. Case in point: We've spotted 2 warning signs for North China Pharmaceutical Company.Ltd you should be aware of, and 1 of them doesn't sit too well with us.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.