YiChang HEC ChangJiang Pharmaceutical (HKG:1558) Could Easily Take On More 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that YiChang HEC ChangJiang Pharmaceutical Co., Ltd. (HKG:1558) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for YiChang HEC ChangJiang Pharmaceutical

What Is YiChang HEC ChangJiang Pharmaceutical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 YiChang HEC ChangJiang Pharmaceutical had CN¥4.48b of debt, an increase on CN¥3.56b, over one year. However, it also had CN¥3.78b in cash, and so its net debt is CN¥698.1m.

A Look At YiChang HEC ChangJiang Pharmaceutical's Liabilities

We can see from the most recent balance sheet that YiChang HEC ChangJiang Pharmaceutical had liabilities of CN¥5.66b falling due within a year, and liabilities of CN¥692.5m due beyond that. Offsetting these obligations, it had cash of CN¥3.78b as well as receivables valued at CN¥1.12b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.45b.

While this might seem like a lot, it is not so bad since YiChang HEC ChangJiang Pharmaceutical has a market capitalization of CN¥5.34b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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.

While YiChang HEC ChangJiang Pharmaceutical's low debt to EBITDA ratio of 0.36 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.4 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Better yet, YiChang HEC ChangJiang Pharmaceutical grew its EBIT by 458% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, YiChang HEC ChangJiang Pharmaceutical generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, YiChang HEC ChangJiang Pharmaceutical's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think YiChang HEC ChangJiang Pharmaceutical's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in YiChang HEC ChangJiang Pharmaceutical, you may well want to click here to check an interactive graph of its earnings per share history.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.