Here's Why Luye Pharma Group (HKG:2186) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Luye Pharma Group Ltd. (HKG:2186) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

See our latest analysis for Luye Pharma Group

What Is Luye Pharma Group's Debt?

As you can see below, Luye Pharma Group had CN¥8.35b of debt at December 2023, down from CN¥9.15b a year prior. However, it also had CN¥6.11b in cash, and so its net debt is CN¥2.25b.

A Look At Luye Pharma Group's Liabilities

We can see from the most recent balance sheet that Luye Pharma Group had liabilities of CN¥8.14b falling due within a year, and liabilities of CN¥3.82b due beyond that. Offsetting this, it had CN¥6.11b in cash and CN¥2.35b in receivables that were due within 12 months. So its liabilities total CN¥3.50b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Luye Pharma Group has a market capitalization of CN¥9.47b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.5 times EBITDA, it is initially surprising to see that Luye Pharma Group's EBIT has low interest coverage of 1.9 times. So one way or the other, it's clear the debt levels are not trivial. One way Luye Pharma Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Luye Pharma Group can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Luye Pharma Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Luye Pharma Group's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at growing its EBIT. When we consider all the factors discussed, it seems to us that Luye Pharma Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Luye Pharma Group's earnings per share history for free.

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.