Health Check: How Prudently Does Hunan Er-Kang Pharmaceutical (SZSE:300267) Use Debt?

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. As with many other companies Hunan Er-Kang Pharmaceutical Co., Ltd (SZSE:300267) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hunan Er-Kang Pharmaceutical

What Is Hunan Er-Kang Pharmaceutical's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Hunan Er-Kang Pharmaceutical had debt of CN¥351.0m, up from CN¥199.0m in one year. But it also has CN¥535.2m in cash to offset that, meaning it has CN¥184.2m net cash.

A Look At Hunan Er-Kang Pharmaceutical's Liabilities

According to the last reported balance sheet, Hunan Er-Kang Pharmaceutical had liabilities of CN¥620.2m due within 12 months, and liabilities of CN¥65.8m due beyond 12 months. Offsetting this, it had CN¥535.2m in cash and CN¥197.4m in receivables that were due within 12 months. So it can boast CN¥46.6m more liquid assets than total liabilities.

This state of affairs indicates that Hunan Er-Kang Pharmaceutical's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥4.79b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Hunan Er-Kang Pharmaceutical boasts net cash, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But it is Hunan Er-Kang Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

In the last year Hunan Er-Kang Pharmaceutical had a loss before interest and tax, and actually shrunk its revenue by 24%, to CN¥1.5b. To be frank that doesn't bode well.

So How Risky Is Hunan Er-Kang Pharmaceutical?

Although Hunan Er-Kang Pharmaceutical had an earnings before interest and tax (EBIT) loss over the last twelve months, it generated positive free cash flow of CN¥47m. So taking that on face value, and considering the net cash situation, we don't think that the stock is too risky in the near term. We'll feel more comfortable with the stock once EBIT is positive, given the lacklustre revenue growth. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Hunan Er-Kang Pharmaceutical 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.