Nang Kuang Pharmaceutical (GTSM:1752) Has A Pretty Healthy Balance Sheet

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.' 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 Nang Kuang Pharmaceutical Co., Ltd. (GTSM:1752) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Nang Kuang Pharmaceutical

What Is Nang Kuang Pharmaceutical's Debt?

The chart below, which you can click on for greater detail, shows that Nang Kuang Pharmaceutical had NT$482.0m in debt in December 2020; about the same as the year before. However, it also had NT$267.9m in cash, and so its net debt is NT$214.1m.

How Strong Is Nang Kuang Pharmaceutical's Balance Sheet?

According to the last reported balance sheet, Nang Kuang Pharmaceutical had liabilities of NT$950.0m due within 12 months, and liabilities of NT$105.6m due beyond 12 months. Offsetting this, it had NT$267.9m in cash and NT$375.8m in receivables that were due within 12 months. So its liabilities total NT$412.0m more than the combination of its cash and short-term receivables.

Given Nang Kuang Pharmaceutical has a market capitalization of NT$3.92b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Nang Kuang Pharmaceutical has a low net debt to EBITDA ratio of only 0.52. And its EBIT covers its interest expense a whopping 2k times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Nang Kuang Pharmaceutical saw its EBIT decline by 8.9% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Nang Kuang Pharmaceutical 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. 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, Nang Kuang Pharmaceutical generated free cash flow amounting to a very robust 97% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that Nang Kuang Pharmaceutical's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Taking all this data into account, it seems to us that Nang Kuang Pharmaceutical takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. For instance, we've identified 2 warning signs for Nang Kuang Pharmaceutical (1 shouldn't be ignored) you should be aware of.

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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