Yuyu Pharma (KRX:000220) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Yuyu Pharma, Inc. (KRX:000220) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Yuyu Pharma

How Much Debt Does Yuyu Pharma Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Yuyu Pharma had debt of ₩29.3b, up from ₩23.3b in one year. However, because it has a cash reserve of ₩24.9b, its net debt is less, at about ₩4.40b.

How Strong Is Yuyu Pharma's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Yuyu Pharma had liabilities of ₩30.7b due within 12 months and liabilities of ₩18.3b due beyond that. Offsetting these obligations, it had cash of ₩24.9b as well as receivables valued at ₩20.0b due within 12 months. So its liabilities total ₩4.19b more than the combination of its cash and short-term receivables.

Since publicly traded Yuyu Pharma shares are worth a total of ₩112.6b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Looking at its net debt to EBITDA of 0.38 and interest cover of 4.3 times, it seems to us that Yuyu Pharma is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Yuyu Pharma grew its EBIT by 4.5% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Yuyu Pharma's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Yuyu Pharma burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Yuyu Pharma's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to handle its debt, based on its EBITDA, is pretty flash. Looking at all this data makes us feel a little cautious about Yuyu Pharma's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For instance, we've identified 2 warning signs for Yuyu Pharma that you should be aware of.

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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