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 Fusen Pharmaceutical Company Limited (HKG:1652) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Fusen Pharmaceutical’s Debt?
You can click the graphic below for the historical numbers, but it shows that Fusen Pharmaceutical had CN¥191.6m of debt in December 2018, down from CN¥398.2m, one year before. But it also has CN¥561.1m in cash to offset that, meaning it has CN¥369.5m net cash.
How Healthy Is Fusen Pharmaceutical’s Balance Sheet?
According to the last reported balance sheet, Fusen Pharmaceutical had liabilities of CN¥451.0m due within 12 months, and liabilities of CN¥96.2m due beyond 12 months. On the other hand, it had cash of CN¥561.1m and CN¥149.9m worth of receivables due within a year. So it can boast CN¥163.8m more liquid assets than total liabilities.
This short term liquidity is a sign that Fusen Pharmaceutical could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Fusen Pharmaceutical has more cash than debt is arguably a good indication that it can manage its debt safely.
Fusen Pharmaceutical’s EBIT was pretty flat over the last year, but that shouldn’t be an issue given the it doesn’t have a lot of debt. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Fusen Pharmaceutical will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Fusen Pharmaceutical 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, Fusen Pharmaceutical recorded free cash flow worth 64% 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 we empathize with investors who find debt concerning, you should keep in mind that Fusen Pharmaceutical has net cash of CN¥370m, as well as more liquid assets than liabilities. So we don’t think Fusen Pharmaceutical’s use of debt is risky. Over time, share prices tend to follow earnings per share, so if you’re interested in Fusen Pharmaceutical, you may well want to click here to check an interactive graph of its earnings per share history.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.