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 Resources Medical Holdings Company Limited (HKG:1515) 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is China Resources Medical Holdings's Debt?
As you can see below, China Resources Medical Holdings had CN¥684.3m of debt at December 2020, down from CN¥833.9m a year prior. However, its balance sheet shows it holds CN¥2.97b in cash, so it actually has CN¥2.29b net cash.
A Look At China Resources Medical Holdings' Liabilities
Zooming in on the latest balance sheet data, we can see that China Resources Medical Holdings had liabilities of CN¥2.21b due within 12 months and liabilities of CN¥415.6m due beyond that. On the other hand, it had cash of CN¥2.97b and CN¥643.4m worth of receivables due within a year. So it can boast CN¥992.3m more liquid assets than total liabilities.
This surplus suggests that China Resources Medical Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that China Resources Medical Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that China Resources Medical Holdings's load is not too heavy, because its EBIT was down 41% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 China Resources Medical Holdings 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While China Resources Medical 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. Over the last three years, China Resources Medical Holdings recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While it is always sensible to investigate a company's debt, in this case China Resources Medical Holdings has CN¥2.29b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in CN¥540m. So is China Resources Medical Holdings's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for China Resources Medical Holdings you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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