Is Sinopharm Group (HKG:1099) Using Too Much 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.' 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 Sinopharm Group Co. Ltd. (HKG:1099) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Sinopharm Group

What Is Sinopharm Group's Net Debt?

As you can see below, Sinopharm Group had CN¥89.9b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥34.4b in cash leading to net debt of about CN¥55.5b.

How Strong Is Sinopharm Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sinopharm Group had liabilities of CN¥281.3b due within 12 months and liabilities of CN¥23.3b due beyond that. Offsetting these obligations, it had cash of CN¥34.4b as well as receivables valued at CN¥241.5b due within 12 months. So its liabilities total CN¥28.7b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Sinopharm Group is worth CN¥66.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 2.2, Sinopharm Group uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. Sinopharm Group grew its EBIT by 8.0% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Sinopharm Group 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. Looking at the most recent three years, Sinopharm Group recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Sinopharm Group's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. It's also worth noting that Sinopharm Group is in the Healthcare industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Sinopharm Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 Sinopharm Group you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.