Stock Analysis

China Resources Pharmaceutical Group (HKG:3320) Takes On Some Risk With Its Use Of Debt

SEHK:3320
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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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, China Resources Pharmaceutical Group Limited (HKG:3320) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See 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$69.1b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have HK$18.4b in cash offsetting this, leading to net debt of about HK$50.7b.

debt-equity-history-analysis
SEHK:3320 Debt to Equity History August 27th 2022

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$146.8b falling due within a year, and liabilities of HK$16.4b due beyond that. On the other hand, it had cash of HK$18.4b and HK$90.1b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$54.8b.

The deficiency here weighs heavily on the HK$31.4b 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'd watch its balance sheet closely, without a doubt. After all, China Resources Pharmaceutical Group would likely require a major re-capitalisation if it had to pay its creditors today.

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 3.9 and its EBIT covered its interest expense 6.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way China Resources Pharmaceutical Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, China Resources Pharmaceutical Group generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

China Resources Pharmaceutical Group's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that China Resources Pharmaceutical Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for China Resources Pharmaceutical Group you should be aware of, and 1 of them is concerning.

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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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.