Grand Pharmaceutical Group (HKG:512) Seems To Use Debt Quite Sensibly

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.' 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. As with many other companies Grand Pharmaceutical Group Limited (HKG:512) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Grand Pharmaceutical Group

What Is Grand Pharmaceutical Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Grand Pharmaceutical Group had debt of HK$3.57b, up from HK$2.89b in one year. However, it also had HK$2.68b in cash, and so its net debt is HK$893.2m.

A Look At Grand Pharmaceutical Group's Liabilities

We can see from the most recent balance sheet that Grand Pharmaceutical Group had liabilities of HK$5.94b falling due within a year, and liabilities of HK$2.11b due beyond that. Offsetting this, it had HK$2.68b in cash and HK$2.94b in receivables that were due within 12 months. So it has liabilities totalling HK$2.43b more than its cash and near-term receivables, combined.

Of course, Grand Pharmaceutical Group has a market capitalization of HK$15.0b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Grand Pharmaceutical Group's net debt is only 0.32 times its EBITDA. And its EBIT easily covers its interest expense, being 43.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Grand Pharmaceutical Group grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. 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 Grand 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, Grand Pharmaceutical Group produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Grand Pharmaceutical Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, Grand Pharmaceutical Group seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. We've identified 1 warning sign with Grand Pharmaceutical Group , 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.