Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 3SBio Inc. (HKG:1530) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.
What Is 3SBio's Net Debt?
As you can see below, 3SBio had CN¥2.87b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has CN¥4.36b in cash, leading to a CN¥1.49b net cash position.
A Look At 3SBio's Liabilities
According to the last reported balance sheet, 3SBio had liabilities of CN¥1.45b due within 12 months, and liabilities of CN¥3.13b due beyond 12 months. On the other hand, it had cash of CN¥4.36b and CN¥983.0m worth of receivables due within a year. So it actually has CN¥761.8m more liquid assets than total liabilities.
This surplus suggests that 3SBio has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that 3SBio has more cash than debt is arguably a good indication that it can manage its debt safely.
On the other hand, 3SBio saw its EBIT drop by 9.1% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. 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 3SBio's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 3SBio 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 most recent three years, 3SBio recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to investigate a company's debt, in this case 3SBio has CN¥1.49b in net cash and a decent-looking balance sheet. So we don't have any problem with 3SBio's use of debt. 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 instance, we've identified 1 warning sign for 3SBio that you should be aware of.
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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