GemPharmatech (SHSE:688046) Seems To Use Debt Quite Sensibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 GemPharmatech Co., Ltd. (SHSE:688046) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for GemPharmatech

How Much Debt Does GemPharmatech Carry?

As you can see below, at the end of March 2024, GemPharmatech had CN¥85.2m of debt, up from CN¥32.1m a year ago. Click the image for more detail. However, it does have CN¥1.25b in cash offsetting this, leading to net cash of CN¥1.16b.

How Healthy Is GemPharmatech's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that GemPharmatech had liabilities of CN¥340.8m due within 12 months and liabilities of CN¥87.4m due beyond that. Offsetting this, it had CN¥1.25b in cash and CN¥324.6m in receivables that were due within 12 months. So it actually has CN¥1.14b more liquid assets than total liabilities.

This excess liquidity suggests that GemPharmatech is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that GemPharmatech has more cash than debt is arguably a good indication that it can manage its debt safely.

And we also note warmly that GemPharmatech grew its EBIT by 11% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine GemPharmatech's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. GemPharmatech 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. Over the last three years, GemPharmatech 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.

Summing Up

While it is always sensible to investigate a company's debt, in this case GemPharmatech has CN¥1.16b in net cash and a decent-looking balance sheet. And it also grew its EBIT by 11% over the last year. So we don't have any problem with GemPharmatech's use of debt. 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 GemPharmatech you should be aware of, and 1 of them is potentially serious.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

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