Is China Resources Pharmaceutical Group (HKG:3320) A Risky Investment?

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 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. We note that China Resources Pharmaceutical Group Limited (HKG:3320) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Resources Pharmaceutical Group

What Is China Resources Pharmaceutical Group's Debt?

As you can see below, at the end of December 2020, China Resources Pharmaceutical Group had HK$54.3b of debt, up from HK$40.1b a year ago. Click the image for more detail. On the flip side, it has HK$45.8b in cash leading to net debt of about HK$8.46b.

A Look At China Resources Pharmaceutical Group's Liabilities

The latest balance sheet data shows that China Resources Pharmaceutical Group had liabilities of HK$122.6b due within a year, and liabilities of HK$6.72b falling due after that. On the other hand, it had cash of HK$45.8b and HK$66.4b worth of receivables due within a year. So it has liabilities totalling HK$17.0b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since China Resources Pharmaceutical Group has a market capitalization of HK$30.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Looking at its net debt to EBITDA of 0.77 and interest cover of 3.8 times, it seems to us that China Resources Pharmaceutical Group is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. If China Resources Pharmaceutical Group can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, China Resources Pharmaceutical Group's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

China Resources Pharmaceutical Group's net debt to EBITDA was a real positive on this analysis, as was its EBIT growth rate. Having said that, its interest cover somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about China Resources Pharmaceutical Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with China Resources Pharmaceutical Group , and understanding them should be part of your investment process.

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. 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.
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