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

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.' 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 China Traditional Chinese Medicine Holdings Co. Limited (HKG:570) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. 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

How Much Debt Does China Traditional Chinese Medicine Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 China Traditional Chinese Medicine Holdings had CN¥7.33b of debt, an increase on CN¥6.44b, over one year. However, it does have CN¥6.14b in cash offsetting this, leading to net debt of about CN¥1.18b.

A Look At China Traditional Chinese Medicine Holdings' Liabilities

The latest balance sheet data shows that China Traditional Chinese Medicine Holdings had liabilities of CN¥12.6b due within a year, and liabilities of CN¥2.64b falling due after that. Offsetting these obligations, it had cash of CN¥6.14b as well as receivables valued at CN¥7.35b due within 12 months. So it has liabilities totalling CN¥1.70b more than its cash and near-term receivables, combined.

Since publicly traded China Traditional Chinese Medicine Holdings shares are worth a total of CN¥15.0b, it seems unlikely that this level of liabilities would be a major 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Traditional Chinese Medicine Holdings's net debt is only 0.43 times its EBITDA. And its EBIT covers its interest expense a whopping 13.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. 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 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 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While China Traditional Chinese Medicine Holdings's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. 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. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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.