We Think China Grand Pharmaceutical and Healthcare Holdings (HKG:512) Can Stay On Top Of Its Debt

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that China Grand Pharmaceutical and Healthcare Holdings Limited (HKG:512) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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, 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.

View our latest analysis for China Grand Pharmaceutical and Healthcare Holdings

How Much Debt Does China Grand Pharmaceutical and Healthcare Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 China Grand Pharmaceutical and Healthcare Holdings had HK$2.37b of debt, an increase on HK$2.03b, over one year. However, because it has a cash reserve of HK$2.36b, its net debt is less, at about HK$11.9m.

A Look At China Grand Pharmaceutical and Healthcare Holdings' Liabilities

The latest balance sheet data shows that China Grand Pharmaceutical and Healthcare Holdings had liabilities of HK$4.30b due within a year, and liabilities of HK$1.34b falling due after that. On the other hand, it had cash of HK$2.36b and HK$1.72b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.57b.

Given China Grand Pharmaceutical and Healthcare Holdings has a market capitalization of HK$24.4b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, China Grand Pharmaceutical and Healthcare Holdings has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With debt at a measly 0.0051 times EBITDA and EBIT covering interest a whopping 16.2 times, it's clear that China Grand Pharmaceutical and Healthcare Holdings is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. In addition to that, we're happy to report that China Grand Pharmaceutical and Healthcare Holdings has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. 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 Grand Pharmaceutical and Healthcare Holdings'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, China Grand Pharmaceutical and Healthcare Holdings recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that China Grand Pharmaceutical and Healthcare Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, China Grand Pharmaceutical and Healthcare Holdings seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. For instance, we've identified 1 warning sign for China Grand Pharmaceutical and Healthcare Holdings that you should be aware of.

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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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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