Does Shanxi Lanhua Sci-Tech VentureLtd (SHSE:600123) Have A Healthy Balance Sheet?

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.' 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. Importantly, Shanxi Lanhua Sci-Tech Venture Co.,Ltd (SHSE:600123) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Shanxi Lanhua Sci-Tech VentureLtd

What Is Shanxi Lanhua Sci-Tech VentureLtd's Debt?

As you can see below, Shanxi Lanhua Sci-Tech VentureLtd had CN¥8.86b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥6.25b in cash offsetting this, leading to net debt of about CN¥2.61b.

A Look At Shanxi Lanhua Sci-Tech VentureLtd's Liabilities

The latest balance sheet data shows that Shanxi Lanhua Sci-Tech VentureLtd had liabilities of CN¥9.01b due within a year, and liabilities of CN¥6.29b falling due after that. Offsetting these obligations, it had cash of CN¥6.25b as well as receivables valued at CN¥1.59b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.47b.

This is a mountain of leverage relative to its market capitalization of CN¥11.8b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shanxi Lanhua Sci-Tech VentureLtd has net debt of just 0.66 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. The modesty of its debt load may become crucial for Shanxi Lanhua Sci-Tech VentureLtd if management cannot prevent a repeat of the 37% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shanxi Lanhua Sci-Tech VentureLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shanxi Lanhua Sci-Tech VentureLtd recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Shanxi Lanhua Sci-Tech VentureLtd's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Shanxi Lanhua Sci-Tech VentureLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Shanxi Lanhua Sci-Tech VentureLtd that 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.