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.' 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. As with many other companies Guobang Pharma Ltd. (SHSE:605507) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

What Is Guobang Pharma's Net Debt?

As you can see below, at the end of December 2023, Guobang Pharma had CN¥963.3m of debt, up from CN¥664.3m a year ago. Click the image for more detail. But it also has CN¥2.56b in cash to offset that, meaning it has CN¥1.60b net cash.

How Strong Is Guobang Pharma's Balance Sheet?

The latest balance sheet data shows that Guobang Pharma had liabilities of CN¥2.45b due within a year, and liabilities of CN¥474.8m falling due after that. Offsetting this, it had CN¥2.56b in cash and CN¥982.1m in receivables that were due within 12 months. So it can boast CN¥617.8m more liquid assets than total liabilities.

This surplus suggests that Guobang Pharma has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Guobang Pharma has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Guobang Pharma's saving grace is its low debt levels, because its EBIT has tanked 31% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Guobang Pharma'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Guobang Pharma 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 last three years, Guobang Pharma saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

While it is always sensible to investigate a company's debt, in this case Guobang Pharma has CN¥1.60b in net cash and a decent-looking balance sheet. So while Guobang Pharma does not have a great balance sheet, it's certainly not too bad. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Guobang Pharma .

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.