China Medical System Holdings (HKG:867) Could Easily Take On More 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.' 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 China Medical System Holdings Limited (HKG:867) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for China Medical System Holdings

What Is China Medical System Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that China Medical System Holdings had CN¥593.1m of debt in December 2020, down from CN¥694.1m, one year before. However, it does have CN¥2.67b in cash offsetting this, leading to net cash of CN¥2.08b.

How Strong Is China Medical System Holdings' Balance Sheet?

We can see from the most recent balance sheet that China Medical System Holdings had liabilities of CN¥912.0m falling due within a year, and liabilities of CN¥686.4m due beyond that. Offsetting these obligations, it had cash of CN¥2.67b as well as receivables valued at CN¥1.79b due within 12 months. So it actually has CN¥2.86b more liquid assets than total liabilities.

This surplus suggests that China Medical System Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that China Medical System Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that China Medical System Holdings grew its EBIT at 17% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Medical System Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While China Medical System Holdings 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. Over the last three years, China Medical System Holdings recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that China Medical System Holdings has net cash of CN¥2.08b, as well as more liquid assets than liabilities. The cherry on top was that in converted 88% of that EBIT to free cash flow, bringing in CN¥2.4b. So we don't think China Medical System Holdings's use of debt is risky. 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. Case in point: We've spotted 1 warning sign for China Medical System Holdings you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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