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. We can see that KPC Pharmaceuticals, Inc. (SHSE:600422) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for KPC Pharmaceuticals
What Is KPC Pharmaceuticals's Debt?
The image below, which you can click on for greater detail, shows that at September 2022 KPC Pharmaceuticals had debt of CN¥996.3m, up from CN¥800.7m in one year. But it also has CN¥1.48b in cash to offset that, meaning it has CN¥480.9m net cash.
A Look At KPC Pharmaceuticals' Liabilities
We can see from the most recent balance sheet that KPC Pharmaceuticals had liabilities of CN¥3.53b falling due within a year, and liabilities of CN¥424.1m due beyond that. Offsetting this, it had CN¥1.48b in cash and CN¥2.97b in receivables that were due within 12 months. So it actually has CN¥488.7m more liquid assets than total liabilities.
This short term liquidity is a sign that KPC Pharmaceuticals could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, KPC Pharmaceuticals boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, KPC Pharmaceuticals saw its EBIT drop by 2.6% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine KPC Pharmaceuticals's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. KPC Pharmaceuticals 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. Over the last three years, KPC Pharmaceuticals reported free cash flow worth 12% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
While it is always sensible to investigate a company's debt, in this case KPC Pharmaceuticals has CN¥480.9m in net cash and a decent-looking balance sheet. So we are not troubled with KPC Pharmaceuticals's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with KPC Pharmaceuticals , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.