ApicHope Pharmaceutical (SZSE:300723) Has A Pretty Healthy Balance Sheet

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 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. As with many other companies ApicHope Pharmaceutical Co., Ltd (SZSE:300723) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

See our latest analysis for ApicHope Pharmaceutical

What Is ApicHope Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that ApicHope Pharmaceutical had debt of CN¥1.06b at the end of September 2023, a reduction from CN¥1.42b over a year. However, because it has a cash reserve of CN¥615.6m, its net debt is less, at about CN¥442.9m.

How Healthy Is ApicHope Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ApicHope Pharmaceutical had liabilities of CN¥1.28b due within 12 months and liabilities of CN¥380.0m due beyond that. On the other hand, it had cash of CN¥615.6m and CN¥351.1m worth of receivables due within a year. So its liabilities total CN¥689.8m more than the combination of its cash and short-term receivables.

Of course, ApicHope Pharmaceutical has a market capitalization of CN¥11.9b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

ApicHope Pharmaceutical's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 86.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, ApicHope Pharmaceutical grew its EBIT by 30% over the last twelve months, and that growth will make it easier to handle its 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 ApicHope 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, ApicHope Pharmaceutical burned a lot of cash. 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

The good news is that ApicHope Pharmaceutical's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. 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 ApicHope Pharmaceutical 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. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with ApicHope Pharmaceutical , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.