These 4 Measures Indicate That Zhongzhi Pharmaceutical Holdings (HKG:3737) Is Using Debt Reasonably Well

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Zhongzhi Pharmaceutical Holdings Limited (HKG:3737) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zhongzhi Pharmaceutical Holdings

What Is Zhongzhi Pharmaceutical Holdings's Debt?

As you can see below, Zhongzhi Pharmaceutical Holdings had CN¥36.0m of debt at December 2022, down from CN¥57.2m a year prior. However, its balance sheet shows it holds CN¥395.7m in cash, so it actually has CN¥359.7m net cash.

How Healthy Is Zhongzhi Pharmaceutical Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhongzhi Pharmaceutical Holdings had liabilities of CN¥731.3m due within 12 months and liabilities of CN¥138.1m due beyond that. Offsetting these obligations, it had cash of CN¥395.7m as well as receivables valued at CN¥311.6m due within 12 months. So its liabilities total CN¥162.1m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Zhongzhi Pharmaceutical Holdings has a market capitalization of CN¥738.5m, 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. Despite its noteworthy liabilities, Zhongzhi Pharmaceutical Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Zhongzhi Pharmaceutical Holdings grew its EBIT by 30% over the last twelve months, and that growth will make it easier to handle its debt. 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 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 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 50% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While Zhongzhi Pharmaceutical Holdings does have more liabilities than liquid assets, it also has net cash of CN¥359.7m. And it impressed us with its EBIT growth of 30% over the last year. So is Zhongzhi Pharmaceutical Holdings's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Zhongzhi Pharmaceutical Holdings , and understanding them should be part of your investment process.

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.

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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.