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 Zhongzhi Pharmaceutical Holdings Limited (HKG:3737) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Zhongzhi Pharmaceutical Holdings Carry?
As you can see below, at the end of June 2019, Zhongzhi Pharmaceutical Holdings had CN¥22.1m of debt, up from CN¥27.5 a year ago. Click the image for more detail. But it also has CN¥325.6m in cash to offset that, meaning it has CN¥303.5m net cash.
How Strong Is Zhongzhi Pharmaceutical Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Zhongzhi Pharmaceutical Holdings had liabilities of CN¥333.8m due within 12 months and liabilities of CN¥98.7m due beyond that. On the other hand, it had cash of CN¥325.6m and CN¥226.5m worth of receivables due within a year. So it actually has CN¥119.5m more liquid assets than total liabilities.
This short term liquidity is a sign that Zhongzhi Pharmaceutical Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Zhongzhi Pharmaceutical Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
Another good sign is that Zhongzhi Pharmaceutical Holdings has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. 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 Zhongzhi Pharmaceutical Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Zhongzhi Pharmaceutical Holdings 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. Considering the last three years, Zhongzhi Pharmaceutical Holdings actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
While it is always sensible to investigate a company's debt, in this case Zhongzhi Pharmaceutical Holdings has CN¥303.5m in net cash and a decent-looking balance sheet. And we liked the look of last year's 25% year-on-year EBIT growth. So we don't think Zhongzhi Pharmaceutical Holdings's use of debt is 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. Be aware that Zhongzhi Pharmaceutical Holdings is showing 1 warning sign in our investment analysis , you should know about...
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.