Is China Traditional Chinese Medicine Holdings (HKG:570) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Traditional Chinese Medicine Holdings Co. Limited (HKG:570) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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 Net Debt?

As you can see below, China Traditional Chinese Medicine Holdings had CN¥7.20b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥5.02b in cash offsetting this, leading to net debt of about CN¥2.18b.

A Look At China Traditional Chinese Medicine Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that China Traditional Chinese Medicine Holdings had liabilities of CN¥10.9b due within 12 months and liabilities of CN¥4.20b due beyond that. Offsetting this, it had CN¥5.02b in cash and CN¥9.67b in receivables that were due within 12 months. So it has liabilities totalling CN¥386.6m more than its cash and near-term receivables, combined.

Since publicly traded China Traditional Chinese Medicine Holdings shares are worth a total of CN¥16.1b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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 net debt of just 0.88 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.1 times, which is more than adequate. The modesty of its debt load may become crucial for China Traditional Chinese Medicine Holdings if management cannot prevent a repeat of the 27% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Traditional Chinese Medicine Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. In the last three years, China Traditional Chinese Medicine Holdings created free cash flow amounting to 16% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

China Traditional Chinese Medicine Holdings's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its interest cover is relatively strong. Looking at all the angles mentioned above, it does seem to us that China Traditional Chinese Medicine Holdings is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. To that end, you should be aware of the 1 warning sign we've spotted with China Traditional Chinese Medicine Holdings .

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.