We Think Grand Pharmaceutical Group (HKG:512) Can Stay On Top Of Its Debt

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Grand Pharmaceutical Group Limited (HKG:512) makes use of debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Grand Pharmaceutical Group

What Is Grand Pharmaceutical Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Grand Pharmaceutical Group had HK$4.20b of debt, an increase on HK$3.57b, over one year. However, it also had HK$2.20b in cash, and so its net debt is HK$2.00b.

How Healthy Is Grand Pharmaceutical Group's Balance Sheet?

According to the last reported balance sheet, Grand Pharmaceutical Group had liabilities of HK$6.50b due within 12 months, and liabilities of HK$1.38b due beyond 12 months. On the other hand, it had cash of HK$2.20b and HK$3.07b worth of receivables due within a year. So it has liabilities totalling HK$2.61b more than its cash and near-term receivables, combined.

Of course, Grand Pharmaceutical Group has a market capitalization of HK$14.2b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Grand Pharmaceutical Group has a low net debt to EBITDA ratio of only 0.63. And its EBIT easily covers its interest expense, being 16.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Grand Pharmaceutical Group grew its EBIT by 13% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Grand Pharmaceutical Group's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Grand Pharmaceutical Group's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! When we consider the range of factors above, it looks like Grand Pharmaceutical Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Grand Pharmaceutical Group , and understanding them should be part of your investment process.

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. 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.