Is Hunan Warrant PharmaceuticalLtd (SHSE:688799) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Hunan Warrant Pharmaceutical Co.,Ltd (SHSE:688799) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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. 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.

See our latest analysis for Hunan Warrant PharmaceuticalLtd

How Much Debt Does Hunan Warrant PharmaceuticalLtd Carry?

As you can see below, at the end of June 2024, Hunan Warrant PharmaceuticalLtd had CN¥69.9m of debt, up from none a year ago. Click the image for more detail. However, it does have CN¥739.8m in cash offsetting this, leading to net cash of CN¥669.9m.

How Healthy Is Hunan Warrant PharmaceuticalLtd's Balance Sheet?

According to the last reported balance sheet, Hunan Warrant PharmaceuticalLtd had liabilities of CN¥338.9m due within 12 months, and liabilities of CN¥122.0m due beyond 12 months. Offsetting these obligations, it had cash of CN¥739.8m as well as receivables valued at CN¥233.5m due within 12 months. So it can boast CN¥512.5m more liquid assets than total liabilities.

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

But the other side of the story is that Hunan Warrant PharmaceuticalLtd saw its EBIT decline by 8.9% over the last year. That sort of decline, if sustained, will obviously make debt harder 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 Hunan Warrant PharmaceuticalLtd'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 company can only pay off debt with cold hard cash, not accounting profits. While Hunan Warrant PharmaceuticalLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Hunan Warrant PharmaceuticalLtd reported free cash flow worth 19% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Hunan Warrant PharmaceuticalLtd has net cash of CN¥669.9m, as well as more liquid assets than liabilities. So we don't have any problem with Hunan Warrant PharmaceuticalLtd's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Hunan Warrant PharmaceuticalLtd is showing 1 warning sign in our investment analysis , you should know about...

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.