Is Charmacy Pharmaceutical (HKG:2289) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Charmacy Pharmaceutical Co., Ltd. (HKG:2289) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Charmacy Pharmaceutical

What Is Charmacy Pharmaceutical's Net Debt?

As you can see below, at the end of December 2020, Charmacy Pharmaceutical had CN¥1.24b of debt, up from CN¥1.09b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥602.0m, its net debt is less, at about CN¥634.4m.

How Healthy Is Charmacy Pharmaceutical's Balance Sheet?

The latest balance sheet data shows that Charmacy Pharmaceutical had liabilities of CN¥2.16b due within a year, and liabilities of CN¥134.9m falling due after that. Offsetting this, it had CN¥602.0m in cash and CN¥808.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥886.3m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥452.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Charmacy Pharmaceutical would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 6.1, it's fair to say Charmacy Pharmaceutical does have a significant amount of debt. However, its interest coverage of 3.0 is reasonably strong, which is a good sign. Given the debt load, it's hardly ideal that Charmacy Pharmaceutical's EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Charmacy Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Charmacy Pharmaceutical actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both Charmacy Pharmaceutical's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We should also note that Healthcare industry companies like Charmacy Pharmaceutical commonly do use debt without problems. After considering the datapoints discussed, we think Charmacy Pharmaceutical has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. To that end, you should learn about the 4 warning signs we've spotted with Charmacy Pharmaceutical (including 2 which can't be ignored) .

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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