These 4 Measures Indicate That Shandong Xinhua Pharmaceutical (HKG:719) Is Using Debt Extensively

Warren Buffett famously said, '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 A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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.

View our latest analysis for Shandong Xinhua Pharmaceutical

What Is Shandong Xinhua Pharmaceutical's Debt?

As you can see below, Shandong Xinhua Pharmaceutical had CN¥1.71b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥952.1m in cash, and so its net debt is CN¥753.6m.

A Look At Shandong Xinhua Pharmaceutical's Liabilities

The latest balance sheet data shows that Shandong Xinhua Pharmaceutical had liabilities of CN¥3.32b due within a year, and liabilities of CN¥304.5m falling due after that. Offsetting these obligations, it had cash of CN¥952.1m as well as receivables valued at CN¥1.14b due within 12 months. So it has liabilities totalling CN¥1.54b more than its cash and near-term receivables, combined.

Since publicly traded Shandong Xinhua Pharmaceutical shares are worth a total of CN¥11.4b, 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.

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 has a low net debt to EBITDA ratio of only 0.89. And its EBIT easily covers its interest expense, being 11.5 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Shandong Xinhua Pharmaceutical's EBIT dived 14%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shandong Xinhua Pharmaceutical reported free cash flow worth 6.7% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

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 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. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 3 warning signs we've spotted with Shandong Xinhua Pharmaceutical .

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.