Here's Why YiChang HEC ChangJiang Pharmaceutical (HKG:1558) Has A Meaningful Debt Burden

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.' 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. Importantly, YiChang HEC ChangJiang Pharmaceutical Co., Ltd. (HKG:1558) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

Check out our latest analysis for YiChang HEC ChangJiang Pharmaceutical

How Much Debt Does YiChang HEC ChangJiang Pharmaceutical Carry?

The chart below, which you can click on for greater detail, shows that YiChang HEC ChangJiang Pharmaceutical had CN¥3.01b in debt in December 2020; about the same as the year before. However, because it has a cash reserve of CN¥2.04b, its net debt is less, at about CN¥965.7m.

How Strong Is YiChang HEC ChangJiang Pharmaceutical's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that YiChang HEC ChangJiang Pharmaceutical had liabilities of CN¥4.16b due within 12 months and liabilities of CN¥296.4m due beyond that. Offsetting these obligations, it had cash of CN¥2.04b as well as receivables valued at CN¥469.5m due within 12 months. So it has liabilities totalling CN¥1.94b more than its cash and near-term receivables, combined.

This deficit isn't so bad because YiChang HEC ChangJiang Pharmaceutical is worth CN¥6.14b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 0.80 and interest cover of 4.8 times, it seems to us that YiChang HEC ChangJiang Pharmaceutical is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that YiChang HEC ChangJiang Pharmaceutical's EBIT was down 58% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 YiChang HEC ChangJiang Pharmaceutical'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, YiChang HEC ChangJiang 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 YiChang HEC ChangJiang Pharmaceutical's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that YiChang HEC ChangJiang Pharmaceutical's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for YiChang HEC ChangJiang Pharmaceutical (of which 1 makes us a bit uncomfortable!) you should know about.

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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