We Think Shandong Xinhua Pharmaceutical (HKG:719) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Shandong Xinhua Pharmaceutical Company Limited (HKG:719) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 Shandong Xinhua Pharmaceutical had debt of CN¥1.73b, up from CN¥1.05b in one year. However, it does have CN¥817.9m in cash offsetting this, leading to net debt of about CN¥916.7m.

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¥2.40b falling due within a year, and liabilities of CN¥1.20b due beyond that. Offsetting this, it had CN¥817.9m in cash and CN¥841.2m in receivables that were due within 12 months. So its liabilities total CN¥1.94b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shandong Xinhua Pharmaceutical has a market capitalization of CN¥5.87b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shandong Xinhua Pharmaceutical's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 11.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Shandong Xinhua Pharmaceutical has increased its EBIT by 5.5% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. 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. 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 15% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On our analysis Shandong Xinhua Pharmaceutical's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Shandong Xinhua Pharmaceutical's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 example - Shandong Xinhua Pharmaceutical has 2 warning signs we think you should be aware of.

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.