Is Shandong Xinhua Pharmaceutical (HKG:719) Using Too Much Debt?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Shandong Xinhua Pharmaceutical Company Limited (HKG:719) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Shandong Xinhua Pharmaceutical

What Is Shandong Xinhua Pharmaceutical's Debt?

The image below, which you can click on for greater detail, shows that Shandong Xinhua Pharmaceutical had debt of CN¥988.4m at the end of September 2020, a reduction from CN¥1.44b over a year. However, it also had CN¥949.3m in cash, and so its net debt is CN¥39.1m.

How Strong Is Shandong Xinhua Pharmaceutical's Balance Sheet?

We can see from the most recent balance sheet that Shandong Xinhua Pharmaceutical had liabilities of CN¥2.12b falling due within a year, and liabilities of CN¥1.34b due beyond that. Offsetting this, it had CN¥949.3m in cash and CN¥694.5m 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.

Shandong Xinhua Pharmaceutical has a market capitalization of CN¥5.15b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. But either way, Shandong Xinhua Pharmaceutical has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). 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).

Shandong Xinhua Pharmaceutical's debt of just 0.051 times EBITDA is really very modest. And EBIT easily covered the interest expense 8.3 times over, lending force to that view. But the bad news is that Shandong Xinhua Pharmaceutical has seen its EBIT plunge 13% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shandong Xinhua Pharmaceutical will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Shandong Xinhua Pharmaceutical's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Shandong Xinhua Pharmaceutical's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its net debt to EBITDA tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Shandong Xinhua Pharmaceutical 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. 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 instance, we've identified 2 warning signs for Shandong Xinhua Pharmaceutical that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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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