Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Zhongzhi Pharmaceutical Holdings Limited (HKG:3737) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Zhongzhi Pharmaceutical Holdings Carry?
As you can see below, at the end of December 2020, Zhongzhi Pharmaceutical Holdings had CN¥78.9m of debt, up from CN¥31.4m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥311.0m in cash, so it actually has CN¥232.1m net cash.
A Look At Zhongzhi Pharmaceutical Holdings' Liabilities
The latest balance sheet data shows that Zhongzhi Pharmaceutical Holdings had liabilities of CN¥485.5m due within a year, and liabilities of CN¥113.3m falling due after that. Offsetting this, it had CN¥311.0m in cash and CN¥285.3m in receivables that were due within 12 months. So these liquid assets roughly match the total liabilities.
This state of affairs indicates that Zhongzhi Pharmaceutical Holdings' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥996.5m company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Zhongzhi Pharmaceutical Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
The good news is that Zhongzhi Pharmaceutical Holdings has increased its EBIT by 8.3% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zhongzhi Pharmaceutical Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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. Looking at the most recent three years, Zhongzhi Pharmaceutical Holdings recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
We could understand if investors are concerned about Zhongzhi Pharmaceutical Holdings's liabilities, but we can be reassured by the fact it has has net cash of CN¥232.1m. On top of that, it increased its EBIT by 8.3% in the last twelve months. So we don't have any problem with Zhongzhi Pharmaceutical Holdings's use of debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Zhongzhi Pharmaceutical Holdings (of which 1 is potentially serious!) you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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