We Think Shandong Buchang Pharmaceuticals (SHSE:603858) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Shandong Buchang Pharmaceuticals Co., Ltd. (SHSE:603858) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Shandong Buchang Pharmaceuticals

What Is Shandong Buchang Pharmaceuticals's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shandong Buchang Pharmaceuticals had CN¥3.15b of debt in September 2023, down from CN¥3.33b, one year before. However, it does have CN¥934.1m in cash offsetting this, leading to net debt of about CN¥2.22b.

How Strong Is Shandong Buchang Pharmaceuticals' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shandong Buchang Pharmaceuticals had liabilities of CN¥5.73b due within 12 months and liabilities of CN¥2.82b due beyond that. Offsetting these obligations, it had cash of CN¥934.1m as well as receivables valued at CN¥1.63b due within 12 months. So it has liabilities totalling CN¥5.99b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Shandong Buchang Pharmaceuticals has a market capitalization of CN¥19.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Shandong Buchang Pharmaceuticals's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 14.3 times, makes us even more comfortable. It is just as well that Shandong Buchang Pharmaceuticals's load is not too heavy, because its EBIT was down 32% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong Buchang Pharmaceuticals's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Shandong Buchang Pharmaceuticals recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Shandong Buchang Pharmaceuticals's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Shandong Buchang Pharmaceuticals's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Shandong Buchang Pharmaceuticals you should be aware of.

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.