Is Tonghua Dongbao Pharmaceutical (SHSE:600867) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Tonghua Dongbao Pharmaceutical Co., Ltd. (SHSE:600867) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Tonghua Dongbao Pharmaceutical

What Is Tonghua Dongbao Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Tonghua Dongbao Pharmaceutical had debt of CN¥492.7m, up from CN¥150.0m in one year. However, it does have CN¥372.8m in cash offsetting this, leading to net debt of about CN¥119.9m.

A Look At Tonghua Dongbao Pharmaceutical's Liabilities

According to the last reported balance sheet, Tonghua Dongbao Pharmaceutical had liabilities of CN¥455.8m due within 12 months, and liabilities of CN¥238.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥372.8m as well as receivables valued at CN¥682.7m due within 12 months. So it actually has CN¥361.7m more liquid assets than total liabilities.

This surplus suggests that Tonghua Dongbao Pharmaceutical has a conservative balance sheet, and could probably eliminate its debt without much difficulty. But either way, Tonghua Dongbao Pharmaceutical has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Tonghua Dongbao Pharmaceutical has net debt of just 0.16 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. In fact Tonghua Dongbao Pharmaceutical's saving grace is its low debt levels, because its EBIT has tanked 43% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Tonghua Dongbao 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, 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. Looking at the most recent three years, Tonghua Dongbao Pharmaceutical recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Based on what we've seen Tonghua Dongbao Pharmaceutical is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Tonghua Dongbao Pharmaceutical's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Tonghua Dongbao Pharmaceutical is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.