We Think Zhejiang Tianyu Pharmaceutical (SZSE:300702) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Zhejiang Tianyu Pharmaceutical Co., Ltd. (SZSE:300702) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Zhejiang Tianyu Pharmaceutical

How Much Debt Does Zhejiang Tianyu Pharmaceutical Carry?

The chart below, which you can click on for greater detail, shows that Zhejiang Tianyu Pharmaceutical had CN¥1.68b in debt in September 2024; about the same as the year before. However, it does have CN¥495.2m in cash offsetting this, leading to net debt of about CN¥1.19b.

How Strong Is Zhejiang Tianyu Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhejiang Tianyu Pharmaceutical had liabilities of CN¥2.61b due within 12 months and liabilities of CN¥286.4m due beyond that. Offsetting these obligations, it had cash of CN¥495.2m as well as receivables valued at CN¥557.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.84b.

While this might seem like a lot, it is not so bad since Zhejiang Tianyu Pharmaceutical has a market capitalization of CN¥5.69b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Zhejiang Tianyu Pharmaceutical's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The silver lining is that Zhejiang Tianyu Pharmaceutical grew its EBIT by 224% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Zhejiang Tianyu Pharmaceutical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. During the last three years, Zhejiang Tianyu Pharmaceutical burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Neither Zhejiang Tianyu Pharmaceutical's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Zhejiang Tianyu Pharmaceutical's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 Zhejiang Tianyu Pharmaceutical is showing 1 warning sign in our investment analysis , 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.