Tonghua Golden-Horse Pharmaceutical Industry CoLtd (SZSE:000766) Seems To Use Debt Quite Sensibly

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. We note that Tonghua Golden-Horse Pharmaceutical Industry Co,Ltd (SZSE:000766) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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 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 Tonghua Golden-Horse Pharmaceutical Industry CoLtd

What Is Tonghua Golden-Horse Pharmaceutical Industry CoLtd's Debt?

As you can see below, Tonghua Golden-Horse Pharmaceutical Industry CoLtd had CN¥1.70b of debt at December 2023, down from CN¥1.79b a year prior. On the flip side, it has CN¥178.5m in cash leading to net debt of about CN¥1.52b.

A Look At Tonghua Golden-Horse Pharmaceutical Industry CoLtd's Liabilities

The latest balance sheet data shows that Tonghua Golden-Horse Pharmaceutical Industry CoLtd had liabilities of CN¥572.5m due within a year, and liabilities of CN¥1.63b falling due after that. Offsetting this, it had CN¥178.5m in cash and CN¥555.1m in receivables that were due within 12 months. So its liabilities total CN¥1.47b more than the combination of its cash and short-term receivables.

Given Tonghua Golden-Horse Pharmaceutical Industry CoLtd has a market capitalization of CN¥15.8b, 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).

Tonghua Golden-Horse Pharmaceutical Industry CoLtd shareholders face the double whammy of a high net debt to EBITDA ratio (7.0), and fairly weak interest coverage, since EBIT is just 1.9 times the interest expense. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Tonghua Golden-Horse Pharmaceutical Industry CoLtd grew its EBIT at 13% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tonghua Golden-Horse Pharmaceutical Industry CoLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Tonghua Golden-Horse Pharmaceutical Industry CoLtd generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

We weren't impressed with Tonghua Golden-Horse Pharmaceutical Industry CoLtd's interest cover, and its net debt to EBITDA made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Tonghua Golden-Horse Pharmaceutical Industry CoLtd is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Tonghua Golden-Horse Pharmaceutical Industry CoLtd (of which 1 can't be ignored!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.