China Resources Pharmaceutical Group (HKG:3320) Has A Somewhat Strained Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 China Resources Pharmaceutical Group Limited (HKG:3320) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China Resources Pharmaceutical Group

What Is China Resources Pharmaceutical Group's Debt?

As you can see below, China Resources Pharmaceutical Group had HK$55.0b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have HK$17.5b in cash offsetting this, leading to net debt of about HK$37.5b.

How Healthy Is China Resources Pharmaceutical Group's Balance Sheet?

We can see from the most recent balance sheet that China Resources Pharmaceutical Group had liabilities of HK$141.3b falling due within a year, and liabilities of HK$12.3b due beyond that. Offsetting these obligations, it had cash of HK$17.5b as well as receivables valued at HK$81.3b due within 12 months. So its liabilities total HK$54.7b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$26.1b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, China Resources Pharmaceutical Group would probably need a major re-capitalization if its creditors were to demand repayment.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

China Resources Pharmaceutical Group has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 3.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Fortunately, China Resources Pharmaceutical Group grew its EBIT by 5.7% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Resources Pharmaceutical 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, China Resources Pharmaceutical Group recorded free cash flow worth 61% 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.

Our View

We'd go so far as to say China Resources Pharmaceutical Group's level of total liabilities was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that China Resources Pharmaceutical Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for China Resources Pharmaceutical Group that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.