These 4 Measures Indicate That China Traditional Chinese Medicine Holdings (HKG:570) Is Using Debt Reasonably Well

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.' 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. We can see that China Traditional Chinese Medicine Holdings Co. Limited (HKG:570) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

See our latest analysis for China Traditional Chinese Medicine Holdings

What Is China Traditional Chinese Medicine Holdings's Net 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¥7.74b, one year before. On the flip side, it has CN¥5.30b in cash leading to net debt of about CN¥618.1m.

A Look At China Traditional Chinese Medicine Holdings' Liabilities

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 this, it had CN¥5.30b in cash and CN¥6.58b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.81b more than its cash and near-term receivables, combined.

Since publicly traded China Traditional Chinese Medicine Holdings shares are worth a total of CN¥16.0b, 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's net debt is only 0.18 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. Also good is that China Traditional Chinese Medicine Holdings grew its EBIT at 18% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into 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. All these things considered, it appears that China Traditional Chinese Medicine Holdings can comfortably handle its current debt levels. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs 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.
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