Is Zhongzhi Pharmaceutical Holdings (HKG:3737) 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.' 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. Importantly, Zhongzhi Pharmaceutical Holdings Limited (HKG:3737) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Zhongzhi Pharmaceutical Holdings

How Much Debt Does Zhongzhi Pharmaceutical Holdings Carry?

The image below, which you can click on for greater detail, shows that Zhongzhi Pharmaceutical Holdings had debt of CN¥48.2m at the end of June 2022, a reduction from CN¥101.4m over a year. But on the other hand it also has CN¥267.6m in cash, leading to a CN¥219.5m net cash position.

How Strong Is Zhongzhi Pharmaceutical Holdings' Balance Sheet?

We can see from the most recent balance sheet that Zhongzhi Pharmaceutical Holdings had liabilities of CN¥461.8m falling due within a year, and liabilities of CN¥120.1m due beyond that. Offsetting this, it had CN¥267.6m in cash and CN¥346.4m in receivables that were due within 12 months. So it actually has CN¥32.2m more liquid assets than total liabilities.

This short term liquidity is a sign that Zhongzhi Pharmaceutical Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Zhongzhi Pharmaceutical Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Zhongzhi Pharmaceutical Holdings's saving grace is its low debt levels, because its EBIT has tanked 39% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zhongzhi Pharmaceutical Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Zhongzhi Pharmaceutical Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Zhongzhi Pharmaceutical Holdings's free cash flow amounted to 26% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Zhongzhi Pharmaceutical Holdings has CN¥219.5m in net cash and a decent-looking balance sheet. So we are not troubled with Zhongzhi Pharmaceutical Holdings's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Zhongzhi Pharmaceutical Holdings you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.