Is Shijiazhuang Shangtai Technology (SZSE:001301) Using Too Much Debt?

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. As with many other companies Shijiazhuang Shangtai Technology Co., Ltd. (SZSE:001301) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Shijiazhuang Shangtai Technology

What Is Shijiazhuang Shangtai Technology's Net Debt?

The image below, which you can click on for greater detail, shows that Shijiazhuang Shangtai Technology had debt of CN¥1.03b at the end of September 2023, a reduction from CN¥1.24b over a year. However, because it has a cash reserve of CN¥709.7m, its net debt is less, at about CN¥319.3m.

A Look At Shijiazhuang Shangtai Technology's Liabilities

The latest balance sheet data shows that Shijiazhuang Shangtai Technology had liabilities of CN¥1.83b due within a year, and liabilities of CN¥590.1m falling due after that. On the other hand, it had cash of CN¥709.7m and CN¥2.80b worth of receivables due within a year. So it actually has CN¥1.09b more liquid assets than total liabilities.

This surplus suggests that Shijiazhuang Shangtai Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shijiazhuang Shangtai Technology's net debt is only 0.25 times its EBITDA. And its EBIT easily covers its interest expense, being 21.5 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Shijiazhuang Shangtai Technology's load is not too heavy, because its EBIT was down 37% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shijiazhuang Shangtai Technology can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shijiazhuang Shangtai Technology burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We feel some trepidation about Shijiazhuang Shangtai Technology's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Shijiazhuang Shangtai Technology's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Shijiazhuang Shangtai Technology (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.