Is Sinopharm Group (HKG:1099) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Sinopharm Group Co. Ltd. (HKG:1099) does use debt in its business. 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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Sinopharm Group

What Is Sinopharm Group's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Sinopharm Group had debt of CN¥77.9b, up from CN¥68.5b in one year. However, it does have CN¥35.9b in cash offsetting this, leading to net debt of about CN¥42.0b.

How Strong Is Sinopharm Group's Balance Sheet?

According to the last reported balance sheet, Sinopharm Group had liabilities of CN¥242.1b due within 12 months, and liabilities of CN¥16.1b due beyond 12 months. Offsetting these obligations, it had cash of CN¥35.9b as well as receivables valued at CN¥211.5b due within 12 months. So its liabilities total CN¥10.8b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sinopharm Group has a market capitalization of CN¥48.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Sinopharm Group has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.5 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw Sinopharm Group grow its EBIT by 8.9% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sinopharm Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Sinopharm Group's free cash flow amounted to 30% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Sinopharm Group's EBIT growth rate was a real positive on this analysis, as was its interest cover. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. We would also note that Healthcare industry companies like Sinopharm Group commonly do use debt without problems. Considering this range of data points, we think Sinopharm Group is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Sinopharm Group , 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.