These 4 Measures Indicate That Shijiazhuang Shangtai Technology (SZSE:001301) Is Using Debt Extensively

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We note that Shijiazhuang Shangtai Technology Co., Ltd. (SZSE:001301) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. 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.

See our latest analysis for Shijiazhuang Shangtai Technology

What Is Shijiazhuang Shangtai Technology's Debt?

As you can see below, Shijiazhuang Shangtai Technology had CN¥1.34b of debt at March 2024, down from CN¥2.16b a year prior. However, it does have CN¥97.6m in cash offsetting this, leading to net debt of about CN¥1.25b.

How Strong Is Shijiazhuang Shangtai Technology's Balance Sheet?

According to the last reported balance sheet, Shijiazhuang Shangtai Technology had liabilities of CN¥1.27b due within 12 months, and liabilities of CN¥561.9m due beyond 12 months. On the other hand, it had cash of CN¥97.6m and CN¥2.54b worth of receivables due within a year. So it can boast CN¥811.3m more liquid assets than total liabilities.

This short term liquidity is a sign that Shijiazhuang Shangtai Technology could probably pay off its debt with ease, as its balance sheet is far from stretched.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shijiazhuang Shangtai Technology has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 28.8 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Shijiazhuang Shangtai Technology if management cannot prevent a repeat of the 54% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shijiazhuang Shangtai Technology's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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, Shijiazhuang Shangtai Technology 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

Neither Shijiazhuang Shangtai Technology's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Shijiazhuang Shangtai Technology's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 3 warning signs for Shijiazhuang Shangtai Technology you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.