Wai Yuen Tong Medicine Holdings (HKG:897) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Wai Yuen Tong Medicine Holdings Limited (HKG:897) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Wai Yuen Tong Medicine Holdings

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

As you can see below, Wai Yuen Tong Medicine Holdings had HK$1.68b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had HK$639.6m in cash, and so its net debt is HK$1.04b.

A Look At Wai Yuen Tong Medicine Holdings' Liabilities

We can see from the most recent balance sheet that Wai Yuen Tong Medicine Holdings had liabilities of HK$1.88b falling due within a year, and liabilities of HK$1.76b due beyond that. Offsetting these obligations, it had cash of HK$639.6m as well as receivables valued at HK$92.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$2.91b.

The deficiency here weighs heavily on the HK$418.8m 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 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).

Wai Yuen Tong Medicine Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (8.1), and fairly weak interest coverage, since EBIT is just 0.99 times the interest expense. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Wai Yuen Tong Medicine Holdings actually grew its EBIT by a hefty 403%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Wai Yuen Tong Medicine Holdings actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Wai Yuen Tong Medicine Holdings's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Wai Yuen Tong Medicine Holdings's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Wai Yuen Tong Medicine Holdings you should be aware of, and 1 of them can't be ignored.

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. 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.