Here's Why China Traditional Chinese Medicine Holdings (HKG:570) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 China Traditional Chinese Medicine Holdings Co. Limited (HKG:570) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Traditional Chinese Medicine Holdings

What Is China Traditional Chinese Medicine Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that China Traditional Chinese Medicine Holdings had CN¥5.92b of debt in June 2021, down from CN¥6.91b, one year before. However, because it has a cash reserve of CN¥5.07b, its net debt is less, at about CN¥855.3m.

How Healthy Is China Traditional Chinese Medicine Holdings' Balance Sheet?

According to the last reported balance sheet, China Traditional Chinese Medicine Holdings had liabilities of CN¥8.71b due within 12 months, and liabilities of CN¥4.98b due beyond 12 months. Offsetting these obligations, it had cash of CN¥5.07b as well as receivables valued at CN¥6.58b due within 12 months. So it has liabilities totalling CN¥2.05b more than its cash and near-term receivables, combined.

Given China Traditional Chinese Medicine Holdings has a market capitalization of CN¥15.3b, it's hard to believe these liabilities pose much threat. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Traditional Chinese Medicine Holdings's net debt is only 0.25 times its EBITDA. And its EBIT covers its interest expense a whopping 14.0 times over. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that China Traditional Chinese Medicine Holdings grew its EBIT by 18% last year, making its debt load easier to handle. 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 Traditional Chinese Medicine 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, China Traditional Chinese Medicine Holdings created free cash flow amounting to 13% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

China Traditional Chinese Medicine Holdings's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that China Traditional Chinese Medicine Holdings can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. For example, we've discovered 1 warning sign for China Traditional Chinese Medicine Holdings that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.