Is Guangzhou Baiyunshan Pharmaceutical Holdings (HKG:874) Using Too Much 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.' 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 Guangzhou Baiyunshan Pharmaceutical Holdings Company Limited (HKG:874) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out the opportunities and risks within the HK Healthcare industry.

What Is Guangzhou Baiyunshan Pharmaceutical Holdings's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Guangzhou Baiyunshan Pharmaceutical Holdings had debt of CN¥10.8b, up from CN¥9.84b in one year. However, it does have CN¥21.7b in cash offsetting this, leading to net cash of CN¥10.9b.

How Strong Is Guangzhou Baiyunshan Pharmaceutical Holdings' Balance Sheet?

The latest balance sheet data shows that Guangzhou Baiyunshan Pharmaceutical Holdings had liabilities of CN¥32.0b due within a year, and liabilities of CN¥3.69b falling due after that. Offsetting these obligations, it had cash of CN¥21.7b as well as receivables valued at CN¥20.0b due within 12 months. So it can boast CN¥6.06b more liquid assets than total liabilities.

This surplus suggests that Guangzhou Baiyunshan Pharmaceutical Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Guangzhou Baiyunshan Pharmaceutical Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that Guangzhou Baiyunshan Pharmaceutical Holdings has increased its EBIT by 5.9% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Guangzhou Baiyunshan Pharmaceutical Holdings's ability to maintain a healthy balance sheet going forward. 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. Guangzhou Baiyunshan Pharmaceutical Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Guangzhou Baiyunshan Pharmaceutical Holdings recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Guangzhou Baiyunshan Pharmaceutical Holdings has net cash of CN¥10.9b, as well as more liquid assets than liabilities. The cherry on top was that in converted 97% of that EBIT to free cash flow, bringing in CN¥1.8b. So is Guangzhou Baiyunshan Pharmaceutical 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. Case in point: We've spotted 2 warning signs for Guangzhou Baiyunshan Pharmaceutical Holdings you should be aware of, and 1 of them can't be ignored.

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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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.