Does China Chemical & Pharmaceutical (TPE:1701) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, China Chemical & Pharmaceutical Co., Ltd. (TPE:1701) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, 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 China Chemical & Pharmaceutical

How Much Debt Does China Chemical & Pharmaceutical Carry?

The chart below, which you can click on for greater detail, shows that China Chemical & Pharmaceutical had NT$3.60b in debt in September 2020; about the same as the year before. However, because it has a cash reserve of NT$843.6m, its net debt is less, at about NT$2.76b.

A Look At China Chemical & Pharmaceutical's Liabilities

According to the last reported balance sheet, China Chemical & Pharmaceutical had liabilities of NT$3.10b due within 12 months, and liabilities of NT$2.45b due beyond 12 months. Offsetting these obligations, it had cash of NT$843.6m as well as receivables valued at NT$2.35b due within 12 months. So it has liabilities totalling NT$2.35b more than its cash and near-term receivables, combined.

This deficit isn't so bad because China Chemical & Pharmaceutical is worth NT$6.96b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

China Chemical & Pharmaceutical's net debt is 4.1 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 27.3 is very high, suggesting that the interest expense on the debt is currently quite low. One way China Chemical & Pharmaceutical could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 19%, as it did over the last year. 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 China Chemical & Pharmaceutical will need earnings to service that debt. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China Chemical & Pharmaceutical reported free cash flow worth 7.4% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On our analysis China Chemical & Pharmaceutical's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about China Chemical & Pharmaceutical'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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for China Chemical & Pharmaceutical (1 can'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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This article by Simply Wall St is general in nature. 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.
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