Is China Medical System Holdings (HKG:867) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that China Medical System Holdings Limited (HKG:867) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for China Medical System Holdings

What Is China Medical System Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 China Medical System Holdings had debt of CN¥1.77b, up from CN¥1.09b in one year. However, its balance sheet shows it holds CN¥5.25b in cash, so it actually has CN¥3.48b net cash.

How Healthy Is China Medical System Holdings' Balance Sheet?

According to the last reported balance sheet, China Medical System Holdings had liabilities of CN¥2.71b due within 12 months, and liabilities of CN¥315.0m due beyond 12 months. Offsetting these obligations, it had cash of CN¥5.25b as well as receivables valued at CN¥2.42b due within 12 months. So it actually has CN¥4.65b more liquid assets than total liabilities.

It's good to see that China Medical System Holdings has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. 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.

Fortunately, China Medical System Holdings grew its EBIT by 9.2% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Medical System Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. China Medical System Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, China Medical System Holdings recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case China Medical System Holdings has CN¥3.48b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥2.4b, being 79% of its EBIT. So is China Medical System Holdings's debt a risk? It doesn't seem so to us. Given China Medical System Holdings has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.