Shenzhen Kangtai Biological Products (SZSE:300601) Seems To Use Debt Quite Sensibly

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.' 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 can see that Shenzhen Kangtai Biological Products Co., Ltd. (SZSE:300601) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shenzhen Kangtai Biological Products

How Much Debt Does Shenzhen Kangtai Biological Products Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shenzhen Kangtai Biological Products had CN¥2.63b of debt, an increase on CN¥2.35b, over one year. However, it does have CN¥997.0m in cash offsetting this, leading to net debt of about CN¥1.64b.

How Strong Is Shenzhen Kangtai Biological Products' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Kangtai Biological Products had liabilities of CN¥2.75b due within 12 months and liabilities of CN¥2.65b due beyond that. Offsetting these obligations, it had cash of CN¥997.0m as well as receivables valued at CN¥2.73b due within 12 months. So it has liabilities totalling CN¥1.68b more than its cash and near-term receivables, combined.

Of course, Shenzhen Kangtai Biological Products has a market capitalization of CN¥21.0b, so these liabilities are probably manageable. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shenzhen Kangtai Biological Products's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 118 times, makes us even more comfortable. Even more impressive was the fact that Shenzhen Kangtai Biological Products grew its EBIT by 339% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shenzhen Kangtai Biological Products can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shenzhen Kangtai Biological Products saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Happily, Shenzhen Kangtai Biological Products's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Shenzhen Kangtai Biological Products can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. For example - Shenzhen Kangtai Biological Products has 2 warning signs we think 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.