Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that NanJing Pharmaceutical Company Limited (SHSE:600713) does use debt in its business. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does NanJing Pharmaceutical Carry?
As you can see below, at the end of September 2023, NanJing Pharmaceutical had CN¥12.8b of debt, up from CN¥10.8b a year ago. Click the image for more detail. However, it does have CN¥1.18b in cash offsetting this, leading to net debt of about CN¥11.6b.
How Strong Is NanJing Pharmaceutical's Balance Sheet?
The latest balance sheet data shows that NanJing Pharmaceutical had liabilities of CN¥23.6b due within a year, and liabilities of CN¥2.58b falling due after that. Offsetting this, it had CN¥1.18b in cash and CN¥23.1b in receivables that were due within 12 months. So it has liabilities totalling CN¥1.88b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since NanJing Pharmaceutical has a market capitalization of CN¥5.15b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 7.3, it's fair to say NanJing Pharmaceutical does have a significant amount of debt. However, its interest coverage of 3.2 is reasonably strong, which is a good sign. Fortunately, NanJing Pharmaceutical grew its EBIT by 6.4% in the last year, slowly shrinking its debt relative to earnings. 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 NanJing 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, NanJing Pharmaceutical saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
On the face of it, NanJing Pharmaceutical's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Healthcare industry companies like NanJing Pharmaceutical commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that NanJing Pharmaceutical's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for NanJing Pharmaceutical you should be aware of, and 1 of them is significant.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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