We Think Gansu Shangfeng CementLtd (SZSE:000672) Is Taking Some Risk With Its Debt

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. Importantly, Gansu Shangfeng Cement Co.,Ltd (SZSE:000672) does carry 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Gansu Shangfeng CementLtd

What Is Gansu Shangfeng CementLtd's Net Debt?

As you can see below, at the end of June 2024, Gansu Shangfeng CementLtd had CN¥4.70b of debt, up from CN¥4.44b a year ago. Click the image for more detail. However, it also had CN¥4.48b in cash, and so its net debt is CN¥220.8m.

How Strong Is Gansu Shangfeng CementLtd's Balance Sheet?

We can see from the most recent balance sheet that Gansu Shangfeng CementLtd had liabilities of CN¥5.09b falling due within a year, and liabilities of CN¥3.28b due beyond that. Offsetting this, it had CN¥4.48b in cash and CN¥1.16b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.73b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Gansu Shangfeng CementLtd has a market capitalization of CN¥7.41b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). 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).

Gansu Shangfeng CementLtd has a low debt to EBITDA ratio of only 0.21. 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 Gansu Shangfeng CementLtd if management cannot prevent a repeat of the 53% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gansu Shangfeng CementLtd 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Gansu Shangfeng CementLtd recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

We feel some trepidation about Gansu Shangfeng CementLtd's difficulty EBIT growth rate, but we've got positives to focus on, too. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Gansu Shangfeng CementLtd is a somewhat risky investment as a result of its debt. 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. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Gansu Shangfeng CementLtd you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.