Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 3SBio Inc. (HKG:1530) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is 3SBio's Debt?
As you can see below, 3SBio had CN¥2.60b of debt at June 2021, down from CN¥4.38b a year prior. However, its balance sheet shows it holds CN¥4.80b in cash, so it actually has CN¥2.20b net cash.
How Healthy Is 3SBio's Balance Sheet?
We can see from the most recent balance sheet that 3SBio had liabilities of CN¥1.33b falling due within a year, and liabilities of CN¥3.08b due beyond that. On the other hand, it had cash of CN¥4.80b and CN¥1.22b worth of receivables due within a year. So it actually has CN¥1.61b more liquid assets than total liabilities.
This short term liquidity is a sign that 3SBio could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, 3SBio boasts net cash, so it's fair to say it does not have a heavy debt load!
Also positive, 3SBio grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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. During the last three years, 3SBio produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that 3SBio has net cash of CN¥2.20b, as well as more liquid assets than liabilities. And we liked the look of last year's 29% year-on-year EBIT growth. So we don't think 3SBio's use of debt is risky. 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. Be aware that 3SBio is showing 2 warning signs in our investment analysis , you should know about...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.