Shandong Xinhua Pharmaceutical (HKG:719) Takes On Some Risk With Its Use Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Shandong Xinhua Pharmaceutical Company Limited (HKG:719) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shandong Xinhua Pharmaceutical

What Is Shandong Xinhua Pharmaceutical's Debt?

As you can see below, Shandong Xinhua Pharmaceutical had CN¥959.5m of debt at September 2022, down from CN¥1.73b a year prior. However, it does have CN¥1.21b in cash offsetting this, leading to net cash of CN¥253.3m.

How Healthy Is Shandong Xinhua Pharmaceutical's Balance Sheet?

According to the last reported balance sheet, Shandong Xinhua Pharmaceutical had liabilities of CN¥3.22b due within 12 months, and liabilities of CN¥779.5m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.21b as well as receivables valued at CN¥1.19b due within 12 months. So it has liabilities totalling CN¥1.60b more than its cash and near-term receivables, combined.

Of course, Shandong Xinhua Pharmaceutical has a market capitalization of CN¥15.5b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Shandong Xinhua Pharmaceutical also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Shandong Xinhua Pharmaceutical if management cannot prevent a repeat of the 28% 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. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Shandong Xinhua Pharmaceutical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Shandong Xinhua Pharmaceutical 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.

Summing Up

Although Shandong Xinhua Pharmaceutical's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥253.3m. So while Shandong Xinhua Pharmaceutical does not have a great balance sheet, it's certainly not too bad. 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 instance, we've identified 3 warning signs for Shandong Xinhua Pharmaceutical (1 can't be ignored) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.