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

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, China Traditional Chinese Medicine Holdings Co. Limited (HKG:570) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

See our latest analysis for China Traditional Chinese Medicine Holdings

What Is China Traditional Chinese Medicine Holdings's Net Debt?

As you can see below, China Traditional Chinese Medicine Holdings had CN¥4.97b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥4.14b in cash, and so its net debt is CN¥825.6m.

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

Zooming in on the latest balance sheet data, we can see that China Traditional Chinese Medicine Holdings had liabilities of CN¥8.76b due within 12 months and liabilities of CN¥4.96b due beyond that. On the other hand, it had cash of CN¥4.14b and CN¥8.48b worth of receivables due within a year. So it has liabilities totalling CN¥1.11b more than its cash and near-term receivables, combined.

Given China Traditional Chinese Medicine Holdings has a market capitalization of CN¥15.5b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

China Traditional Chinese Medicine Holdings has a low net debt to EBITDA ratio of only 0.25. And its EBIT covers its interest expense a whopping 17.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that China Traditional Chinese Medicine Holdings has increased its EBIT by 9.5% over twelve months, which should ease any concerns about debt repayment. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, China Traditional Chinese Medicine Holdings actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

The good news is that China Traditional Chinese Medicine Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with China Traditional Chinese Medicine Holdings , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.