These 4 Measures Indicate That Johnson Chemical Pharmaceutical Works (GTSM:4747) Is Using Debt Reasonably Well

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.' 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. Importantly, Johnson Chemical Pharmaceutical Works Co., Ltd. (GTSM:4747) does carry debt. But the real question is whether this debt is making the company risky.

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. 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. 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 Johnson Chemical Pharmaceutical Works

What Is Johnson Chemical Pharmaceutical Works's Net Debt?

As you can see below, at the end of September 2020, Johnson Chemical Pharmaceutical Works had NT$150.0m of debt, up from none a year ago. Click the image for more detail. But it also has NT$308.0m in cash to offset that, meaning it has NT$158.0m net cash.

How Strong Is Johnson Chemical Pharmaceutical Works' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Johnson Chemical Pharmaceutical Works had liabilities of NT$244.9m due within 12 months and liabilities of NT$1.29m due beyond that. Offsetting this, it had NT$308.0m in cash and NT$83.0m in receivables that were due within 12 months. So it can boast NT$144.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Johnson Chemical Pharmaceutical Works could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Johnson Chemical Pharmaceutical Works has more cash than debt is arguably a good indication that it can manage its debt safely.

And we also note warmly that Johnson Chemical Pharmaceutical Works grew its EBIT by 15% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Johnson Chemical Pharmaceutical Works will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Johnson Chemical Pharmaceutical Works may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Johnson Chemical Pharmaceutical Works created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Johnson Chemical Pharmaceutical Works has net cash of NT$158.0m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 15% over the last year. So we don't think Johnson Chemical Pharmaceutical Works's use of debt is risky. 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. For example Johnson Chemical Pharmaceutical Works has 2 warning signs (and 1 which can't be ignored) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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