Health Check: How Prudently Does Wai Yuen Tong Medicine Holdings (HKG:897) Use Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that Wai Yuen Tong Medicine Holdings Limited (HKG:897) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Wai Yuen Tong Medicine Holdings

What Is Wai Yuen Tong Medicine Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Wai Yuen Tong Medicine Holdings had debt of HK$1.80b, up from HK$921.6m in one year. However, because it has a cash reserve of HK$638.1m, its net debt is less, at about HK$1.17b.

How Strong Is Wai Yuen Tong Medicine Holdings's Balance Sheet?

According to the last reported balance sheet, Wai Yuen Tong Medicine Holdings had liabilities of HK$2.80b due within 12 months, and liabilities of HK$1.83b due beyond 12 months. On the other hand, it had cash of HK$638.1m and HK$275.1m worth of receivables due within a year. So its liabilities total HK$3.71b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$511.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Wai Yuen Tong Medicine Holdings would probably need a major re-capitalization if its creditors were to demand repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Wai Yuen Tong Medicine Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Wai Yuen Tong Medicine Holdings wasn't profitable at an EBIT level, but managed to grow its revenue by 23%, to HK$849m. With any luck the company will be able to grow its way to profitability.

Caveat Emptor

Despite the top line growth, Wai Yuen Tong Medicine Holdings still had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable HK$82m at the EBIT level. Reflecting on this and the significant total liabilities, it's hard to know what to say about the stock because of our intense dis-affinity for it. Sure, the company might have a nice story about how they are going on to a brighter future. But the reality is that it is low on liquid assets relative to liabilities, and it burned through HK$38m in the last year. So is this a high risk stock? We think so, and we'd avoid it. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Wai Yuen Tong Medicine Holdings (including 1 which is can't be ignored) .

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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