Is Wai Yuen Tong Medicine Holdings (HKG:897) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Wai Yuen Tong Medicine Holdings Limited (HKG:897) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Wai Yuen Tong Medicine Holdings

What Is Wai Yuen Tong Medicine Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Wai Yuen Tong Medicine Holdings had HK$1.83b in debt in September 2021; about the same as the year before. However, it does have HK$727.3m in cash offsetting this, leading to net debt of about HK$1.11b.

A Look At Wai Yuen Tong Medicine Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Wai Yuen Tong Medicine Holdings had liabilities of HK$2.37b due within 12 months and liabilities of HK$1.63b due beyond that. Offsetting these obligations, it had cash of HK$727.3m as well as receivables valued at HK$242.6m due within 12 months. So it has liabilities totalling HK$3.02b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$344.9m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. 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.

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). 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).

Weak interest cover of 0.98 times and a disturbingly high net debt to EBITDA ratio of 8.6 hit our confidence in Wai Yuen Tong Medicine Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Wai Yuen Tong Medicine Holdings is that it turned last year's EBIT loss into a gain of HK$65m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Wai Yuen Tong Medicine Holdings's earnings that will influence how the balance sheet holds up in the future. 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Wai Yuen Tong Medicine Holdings actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Wai Yuen Tong Medicine Holdings's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Wai Yuen Tong Medicine Holdings's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. To that end, you should be aware of the 2 warning signs we've spotted with Wai Yuen Tong Medicine Holdings .

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.