These 4 Measures Indicate That Yifan Pharmaceutical (SZSE:002019) Is Using Debt Extensively

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. We note that Yifan Pharmaceutical Co., Ltd. (SZSE:002019) does have debt on its balance sheet. 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Yifan Pharmaceutical

What Is Yifan Pharmaceutical's Debt?

You can click the graphic below for the historical numbers, but it shows that Yifan Pharmaceutical had CN¥1.95b of debt in March 2024, down from CN¥2.24b, one year before. On the flip side, it has CN¥835.6m in cash leading to net debt of about CN¥1.12b.

How Healthy Is Yifan Pharmaceutical's Balance Sheet?

We can see from the most recent balance sheet that Yifan Pharmaceutical had liabilities of CN¥2.48b falling due within a year, and liabilities of CN¥954.8m due beyond that. Offsetting these obligations, it had cash of CN¥835.6m as well as receivables valued at CN¥1.44b due within 12 months. So it has liabilities totalling CN¥1.15b more than its cash and near-term receivables, combined.

Since publicly traded Yifan Pharmaceutical shares are worth a total of CN¥16.0b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

While Yifan Pharmaceutical's debt to EBITDA ratio (3.2) suggests that it uses some debt, its interest cover is very weak, at 1.5, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Yifan Pharmaceutical improved its EBIT by 7.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Yifan Pharmaceutical'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Yifan Pharmaceutical saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Yifan Pharmaceutical's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at staying on top of its total liabilities. When we consider all the factors discussed, it seems to us that Yifan Pharmaceutical is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Even though Yifan Pharmaceutical lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.