Here's Why LanZhou Foci PharmaceuticalLtd (SZSE:002644) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, LanZhou Foci Pharmaceutical Co.,Ltd. (SZSE:002644) does carry debt. But is this debt a concern to shareholders?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for LanZhou Foci PharmaceuticalLtd

What Is LanZhou Foci PharmaceuticalLtd's Debt?

As you can see below, LanZhou Foci PharmaceuticalLtd had CN¥38.1m of debt at September 2024, down from CN¥57.5m a year prior. But it also has CN¥351.6m in cash to offset that, meaning it has CN¥313.6m net cash.

How Strong Is LanZhou Foci PharmaceuticalLtd's Balance Sheet?

We can see from the most recent balance sheet that LanZhou Foci PharmaceuticalLtd had liabilities of CN¥409.2m falling due within a year, and liabilities of CN¥268.4m due beyond that. Offsetting these obligations, it had cash of CN¥351.6m as well as receivables valued at CN¥426.6m due within 12 months. So it can boast CN¥100.6m more liquid assets than total liabilities.

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

In fact LanZhou Foci PharmaceuticalLtd's saving grace is its low debt levels, because its EBIT has tanked 45% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is LanZhou Foci PharmaceuticalLtd'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 company can only pay off debt with cold hard cash, not accounting profits. LanZhou Foci PharmaceuticalLtd 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, LanZhou Foci PharmaceuticalLtd reported free cash flow worth 3.4% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that LanZhou Foci PharmaceuticalLtd has net cash of CN¥313.6m, as well as more liquid assets than liabilities. So we are not troubled with LanZhou Foci PharmaceuticalLtd's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that LanZhou Foci PharmaceuticalLtd is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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.

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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.