We Think China Pioneer Pharma Holdings (HKG:1345) Can Stay On Top Of Its Debt

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.' 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 China Pioneer Pharma Holdings Limited (HKG:1345) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. 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 China Pioneer Pharma Holdings

What Is China Pioneer Pharma Holdings's Debt?

The image below, which you can click on for greater detail, shows that China Pioneer Pharma Holdings had debt of CN¥15.1m at the end of December 2020, a reduction from CN¥48.8m over a year. But it also has CN¥254.6m in cash to offset that, meaning it has CN¥239.5m net cash.

How Healthy Is China Pioneer Pharma Holdings' Balance Sheet?

We can see from the most recent balance sheet that China Pioneer Pharma Holdings had liabilities of CN¥484.5m falling due within a year, and liabilities of CN¥32.3m due beyond that. Offsetting these obligations, it had cash of CN¥254.6m as well as receivables valued at CN¥391.4m due within 12 months. So it actually has CN¥129.2m more liquid assets than total liabilities.

This surplus suggests that China Pioneer Pharma Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that China Pioneer Pharma Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact China Pioneer Pharma Holdings's saving grace is its low debt levels, because its EBIT has tanked 47% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Pioneer Pharma Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While China Pioneer Pharma Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, China Pioneer Pharma Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that China Pioneer Pharma Holdings has net cash of CN¥239.5m, as well as more liquid assets than liabilities. The cherry on top was that in converted 110% of that EBIT to free cash flow, bringing in -CN¥2.7m. So is China Pioneer Pharma Holdings's debt a risk? It doesn't seem so to us. 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 3 warning signs for China Pioneer Pharma Holdings (of which 1 shouldn't be ignored!) you should know about.

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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