We Think Guobang Pharma (SHSE:605507) 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.' 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 Guobang Pharma Ltd. (SHSE:605507) makes use of debt. But should shareholders be worried about its use of debt?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Guobang Pharma

What Is Guobang Pharma's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Guobang Pharma had debt of CN¥883.2m, up from CN¥755.6m in one year. However, its balance sheet shows it holds CN¥2.39b in cash, so it actually has CN¥1.50b net cash.

A Look At Guobang Pharma's Liabilities

The latest balance sheet data shows that Guobang Pharma had liabilities of CN¥2.06b due within a year, and liabilities of CN¥415.9m falling due after that. Offsetting this, it had CN¥2.39b in cash and CN¥922.3m in receivables that were due within 12 months. So it actually has CN¥837.9m more liquid assets than total liabilities.

This short term liquidity is a sign that Guobang Pharma could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Guobang Pharma has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Guobang Pharma if management cannot prevent a repeat of the 25% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Guobang Pharma'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Guobang Pharma may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Guobang Pharma burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Guobang Pharma has net cash of CN¥1.50b, as well as more liquid assets than liabilities. So although we see some areas for improvement, we're not too worried about Guobang Pharma's balance sheet. 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. For example Guobang Pharma has 2 warning signs (and 1 which is potentially serious) we think you should know about.

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.