These 4 Measures Indicate That Sichuan Kelun Pharmaceutical (SZSE:002422) Is Using Debt Safely

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Sichuan Kelun Pharmaceutical Co., Ltd. (SZSE:002422) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Sichuan Kelun Pharmaceutical

How Much Debt Does Sichuan Kelun Pharmaceutical Carry?

As you can see below, Sichuan Kelun Pharmaceutical had CN¥7.58b of debt at September 2023, down from CN¥12.5b a year prior. However, it does have CN¥6.94b in cash offsetting this, leading to net debt of about CN¥634.3m.

A Look At Sichuan Kelun Pharmaceutical's Liabilities

The latest balance sheet data shows that Sichuan Kelun Pharmaceutical had liabilities of CN¥9.54b due within a year, and liabilities of CN¥4.22b falling due after that. Offsetting this, it had CN¥6.94b in cash and CN¥6.39b in receivables that were due within 12 months. So it has liabilities totalling CN¥420.4m more than its cash and near-term receivables, combined.

Having regard to Sichuan Kelun Pharmaceutical's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥40.1b company is struggling for cash, we still think it's worth monitoring its balance sheet.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Sichuan Kelun Pharmaceutical's net debt is only 0.16 times its EBITDA. And its EBIT easily covers its interest expense, being 359 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Sichuan Kelun Pharmaceutical has been able to increase its EBIT by 21% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sichuan Kelun 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Sichuan Kelun Pharmaceutical actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Sichuan Kelun Pharmaceutical's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! It looks Sichuan Kelun Pharmaceutical has no trouble standing on its own two feet, and it has no reason to fear its lenders. To our minds it has a healthy happy balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Sichuan Kelun Pharmaceutical you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.