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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Sino Biopharmaceutical Limited (HKG:1177) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Sino Biopharmaceutical Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Sino Biopharmaceutical had CN¥3.35b of debt, an increase on CN¥3.07b, over one year. However, it does have CN¥9.00b in cash offsetting this, leading to net cash of CN¥5.64b.
How Healthy Is Sino Biopharmaceutical's Balance Sheet?
According to the last reported balance sheet, Sino Biopharmaceutical had liabilities of CN¥10.9b due within 12 months, and liabilities of CN¥2.56b due beyond 12 months. On the other hand, it had cash of CN¥9.00b and CN¥3.09b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.38b.
This state of affairs indicates that Sino Biopharmaceutical's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the CN¥105.8b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Sino Biopharmaceutical boasts net cash, so it's fair to say it does not have a heavy debt load!
Also positive, Sino Biopharmaceutical grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sino Biopharmaceutical can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Sino Biopharmaceutical has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Sino Biopharmaceutical recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Sino Biopharmaceutical has CN¥5.6b in net cash. The cherry on top was that in converted 78% of that EBIT to free cash flow, bringing in CN¥3.4b. So is Sino Biopharmaceutical's debt a risk? It doesn't seem so to us. We'd be very excited to see if Sino Biopharmaceutical insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.