These 4 Measures Indicate That Charmacy Pharmaceutical (HKG:2289) Is Using Debt Reasonably Well

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Charmacy Pharmaceutical Co., Ltd. (HKG:2289) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Charmacy Pharmaceutical

How Much Debt Does Charmacy Pharmaceutical Carry?

The image below, which you can click on for greater detail, shows that Charmacy Pharmaceutical had debt of CN¥678.1m at the end of June 2023, a reduction from CN¥1.13b over a year. However, it does have CN¥456.2m in cash offsetting this, leading to net debt of about CN¥222.0m.

How Strong Is Charmacy Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Charmacy Pharmaceutical had liabilities of CN¥2.25b due within 12 months and liabilities of CN¥14.6m due beyond that. Offsetting this, it had CN¥456.2m in cash and CN¥905.1m in receivables that were due within 12 months. So its liabilities total CN¥899.1m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥1.41b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Charmacy Pharmaceutical 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 3.4 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly, Charmacy Pharmaceutical grew its EBIT by 61% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Charmacy Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Charmacy Pharmaceutical's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for Charmacy Pharmaceutical was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. It's also worth noting that Charmacy Pharmaceutical 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 Charmacy Pharmaceutical's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For example Charmacy Pharmaceutical has 3 warning signs (and 2 which can't be ignored) we think 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.