We Think China Chemical & Pharmaceutical (TPE:1701) Can Stay On Top Of Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that China Chemical & Pharmaceutical Co., Ltd. (TPE:1701) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Chemical & Pharmaceutical

What Is China Chemical & Pharmaceutical's Debt?

You can click the graphic below for the historical numbers, but it shows that China Chemical & Pharmaceutical had NT$3.42b of debt in December 2020, down from NT$3.60b, one year before. However, it also had NT$1.03b in cash, and so its net debt is NT$2.39b.

How Strong Is China Chemical & Pharmaceutical's Balance Sheet?

We can see from the most recent balance sheet that China Chemical & Pharmaceutical had liabilities of NT$3.31b falling due within a year, and liabilities of NT$2.42b due beyond that. On the other hand, it had cash of NT$1.03b and NT$2.44b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NT$2.26b.

While this might seem like a lot, it is not so bad since China Chemical & Pharmaceutical has a market capitalization of NT$6.84b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Chemical & Pharmaceutical has a debt to EBITDA ratio of 3.5, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 34.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. If China Chemical & Pharmaceutical can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, China Chemical & Pharmaceutical's free cash flow amounted to 35% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for China Chemical & Pharmaceutical was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit handle its debt, based on its EBITDA,. When we consider all the elements mentioned above, it seems to us that China Chemical & Pharmaceutical is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Case in point: We've spotted 2 warning signs for China Chemical & Pharmaceutical you should be aware of.

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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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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