Here's Why Hainan Huluwa Pharmaceutical Group (SHSE:605199) Has A Meaningful Debt Burden

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Hainan Huluwa Pharmaceutical Group Co., Ltd. (SHSE:605199) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Hainan Huluwa Pharmaceutical Group

How Much Debt Does Hainan Huluwa Pharmaceutical Group Carry?

As you can see below, at the end of June 2024, Hainan Huluwa Pharmaceutical Group had CN¥1.34b of debt, up from CN¥952.7m a year ago. Click the image for more detail. However, it also had CN¥312.9m in cash, and so its net debt is CN¥1.02b.

A Look At Hainan Huluwa Pharmaceutical Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Hainan Huluwa Pharmaceutical Group had liabilities of CN¥1.22b due within 12 months and liabilities of CN¥702.6m due beyond that. Offsetting this, it had CN¥312.9m in cash and CN¥596.4m in receivables that were due within 12 months. So its liabilities total CN¥1.01b more than the combination of its cash and short-term receivables.

Given Hainan Huluwa Pharmaceutical Group has a market capitalization of CN¥5.45b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

As it happens Hainan Huluwa Pharmaceutical Group has a fairly concerning net debt to EBITDA ratio of 6.8 but very strong interest coverage of 10.8. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. The bad news is that Hainan Huluwa Pharmaceutical Group saw its EBIT decline by 19% over the last year. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. During the last three years, Hainan Huluwa Pharmaceutical Group burned a lot of cash. 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

To be frank both Hainan Huluwa Pharmaceutical Group's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Hainan Huluwa Pharmaceutical Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 instance, we've identified 4 warning signs for Hainan Huluwa Pharmaceutical Group (2 are a bit concerning) 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.