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. We note that China Resources Pharmaceutical Group Limited (HKG:3320) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is China Resources Pharmaceutical Group's Debt?
As you can see below, China Resources Pharmaceutical Group had HK$77.5b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$30.6b in cash leading to net debt of about HK$46.9b.
How Healthy Is China Resources Pharmaceutical Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Resources Pharmaceutical Group had liabilities of HK$159.7b due within 12 months and liabilities of HK$17.6b due beyond that. Offsetting these obligations, it had cash of HK$30.6b as well as receivables valued at HK$120.4b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$26.4b.
This deficit is considerable relative to its market capitalization of HK$29.8b, so it does suggest shareholders should keep an eye on China Resources Pharmaceutical Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
China Resources Pharmaceutical Group has a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 5.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. 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. There's no doubt that we learn most about debt from the balance sheet. 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 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 61% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
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. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. 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 is concerning...
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.
China Resources Pharmaceutical Group
China Resources Pharmaceutical Group Limited, an investment holding company, engages in the research and development, manufacture, distribution, and retail of pharmaceutical and other healthcare products in Mainland China and Hong Kong.
Undervalued with moderate growth potential.