David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies China Traditional Chinese Medicine Holdings Co.Limited (HKG:570) uses debt. But the real question is whether this debt makes the business risky.
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business 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.
Check out our latest analysis for China Traditional Chinese Medicine Holdings
How much debt does China Traditional Chinese Medicine Holdings have?
You can click on the graph below for historical figures, but it shows that in June 2022, China Traditional Chinese Medicine Holdings had 7.33 billion yen in debt, an increase from 6.44 billion yen, over a year. However, he has 6.14 billion Canadian yen in cash to offset this, resulting in a net debt of approximately 1.18 billion Canadian yen.
A look at the liabilities of China Traditional Chinese Medicine Holdings
The latest balance sheet data shows that China Traditional Chinese Medicine Holdings had liabilities of 12.6 billion yen maturing within the year, and liabilities of 2.64 billion yen maturing thereafter. In compensation for these obligations, it had cash of 6.14 billion yen as well as receivables valued at 7.35 billion yen due within 12 months. It therefore has liabilities totaling 1.70 billion Canadian yen more than its cash and short-term receivables, combined.
Given that the publicly traded shares of China Traditional Chinese Medicine Holdings are worth a total of 15.0 billion Canadian yen, it seems unlikely that this level of liability is a major threat. But there are enough liabilities that we certainly recommend that shareholders continue to monitor the balance sheet in the future.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
China Traditional Chinese Medicine Holdings’ net debt is only 0.43 times its EBITDA. And its EBIT covers its interest charges 13.4 times. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Its low leverage could become crucial for China Traditional Chinese Medicine Holdings if management cannot prevent a repeat of the 27% reduction in EBIT over the past year. When it comes to paying off debt, lower income is no more helpful than sugary sodas for your health. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine China Traditional Chinese Medicine Holdings’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, China Traditional Chinese Medicine Holdings has created free cash flow of 15% of its EBIT, an uninspiring performance. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
While the EBIT growth rate of China Traditional Chinese Medicine Holdings makes us nervous. Namely its interest coverage and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it seems to us that China Traditional Chinese Medicine Holdings is a somewhat risky investment due to its leverage. This isn’t necessarily a bad thing, since leverage can increase return on equity, but it is something to be aware of. Given our reservations about the company’s balance sheet, it seems a good idea to check whether any insiders have sold shares recently.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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