Does China Resources Pharmaceutical Group (HKG:3320) Have A Healthy Balance Sheet?

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 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. As with many other companies China Resources Pharmaceutical Group Limited (HKG:3320) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 China Resources Pharmaceutical Group had HK$78.9b of debt, an increase on HK$75.1b, over one year. However, because it has a cash reserve of HK$30.6b, its net debt is less, at about HK$48.3b.

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

According to the last reported balance sheet, China Resources Pharmaceutical Group had liabilities of HK$159.7b due within 12 months, and liabilities of HK$17.6b due beyond 12 months. On the other hand, it had cash of HK$30.6b and HK$120.4b worth of receivables due within a year. So its liabilities total HK$26.3b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$31.4b, so it does suggest shareholders should keep an eye on China Resources Pharmaceutical Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

China Resources Pharmaceutical Group has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 5.1 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 12%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Resources Pharmaceutical Group'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Resources Pharmaceutical Group produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

While China Resources Pharmaceutical Group's level of total liabilities does give us pause, its conversion of EBIT to free cash flow and EBIT growth rate suggest it can stay on top of its debt load. We think that China Resources Pharmaceutical Group's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Be aware that China Resources Pharmaceutical Group is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

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.