Is Shandong Xinhua Pharmaceutical (HKG:719) 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. Importantly, Shandong Xinhua Pharmaceutical Company Limited (HKG:719) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that 719 is potentially overvalued!

How Much Debt Does Shandong Xinhua Pharmaceutical Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Shandong Xinhua Pharmaceutical had CN¥1.89b of debt, an increase on CN¥1.73b, over one year. However, because it has a cash reserve of CN¥1.21b, its net debt is less, at about CN¥678.5m.

How Healthy Is Shandong Xinhua Pharmaceutical's Balance Sheet?

We can see from the most recent balance sheet that Shandong Xinhua Pharmaceutical had liabilities of CN¥3.22b falling due within a year, and liabilities of CN¥779.5m due beyond that. Offsetting these obligations, it had cash of CN¥1.21b as well as receivables valued at CN¥1.19b due within 12 months. So its liabilities total CN¥1.60b more than the combination of its cash and short-term receivables.

Given Shandong Xinhua Pharmaceutical has a market capitalization of CN¥13.0b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Shandong Xinhua Pharmaceutical's net debt is only 0.83 times its EBITDA. And its EBIT easily covers its interest expense, being 12.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Shandong Xinhua Pharmaceutical's load is not too heavy, because its EBIT was down 28% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shandong Xinhua Pharmaceutical's earnings that will influence how the balance sheet holds up in the future. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Shandong Xinhua Pharmaceutical created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Shandong Xinhua Pharmaceutical's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Shandong Xinhua Pharmaceutical has 2 warning signs we think 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. 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.