Hainan Huluwa Pharmaceutical Group (SHSE:605199) Has A Somewhat Strained 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 Hainan Huluwa Pharmaceutical Group Co., Ltd. (SHSE:605199) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hainan Huluwa Pharmaceutical Group

What Is Hainan Huluwa Pharmaceutical Group's Debt?

As you can see below, at the end of September 2024, Hainan Huluwa Pharmaceutical Group had CN¥1.32b of debt, up from CN¥1.12b a year ago. Click the image for more detail. However, it does have CN¥143.6m in cash offsetting this, leading to net debt of about CN¥1.18b.

How Strong Is Hainan Huluwa Pharmaceutical Group's Balance Sheet?

We can see from the most recent balance sheet that Hainan Huluwa Pharmaceutical Group had liabilities of CN¥1.22b falling due within a year, and liabilities of CN¥695.4m due beyond that. Offsetting these obligations, it had cash of CN¥143.6m as well as receivables valued at CN¥696.2m due within 12 months. So its liabilities total CN¥1.07b more than the combination of its cash and short-term receivables.

Since publicly traded Hainan Huluwa Pharmaceutical Group shares are worth a total of CN¥7.22b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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

As it happens Hainan Huluwa Pharmaceutical Group has a fairly concerning net debt to EBITDA ratio of 7.0 but very strong interest coverage of 10.2. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Unfortunately, Hainan Huluwa Pharmaceutical Group's EBIT flopped 11% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hainan Huluwa Pharmaceutical Group 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Hainan Huluwa Pharmaceutical Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Hainan Huluwa Pharmaceutical Group's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Hainan Huluwa Pharmaceutical Group's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 5 warning signs for Hainan Huluwa Pharmaceutical Group you should be aware of, and 3 of them are a bit concerning.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.