Shanghai Environment Group (SHSE:601200) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Shanghai Environment Group Co., Ltd (SHSE:601200) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Shanghai Environment Group

What Is Shanghai Environment Group's Net Debt?

As you can see below, Shanghai Environment Group had CN¥10.0b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥940.0m in cash, and so its net debt is CN¥9.06b.

How Healthy Is Shanghai Environment Group's Balance Sheet?

We can see from the most recent balance sheet that Shanghai Environment Group had liabilities of CN¥5.95b falling due within a year, and liabilities of CN¥10.8b due beyond that. Offsetting these obligations, it had cash of CN¥940.0m as well as receivables valued at CN¥4.20b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥11.6b.

When you consider that this deficiency exceeds the company's CN¥10.8b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Environment Group has a rather high debt to EBITDA ratio of 5.4 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.7 times, suggesting it can responsibly service its obligations. Notably, Shanghai Environment Group's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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 Shanghai Environment Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Shanghai Environment Group's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Shanghai Environment Group's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. Overall, it seems to us that Shanghai Environment Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 2 warning signs for Shanghai Environment Group (1 is a bit concerning) 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.