Shanghai Pret Composites (SZSE:002324) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Shanghai Pret Composites Co., Ltd. (SZSE:002324) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Shanghai Pret Composites

What Is Shanghai Pret Composites's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shanghai Pret Composites had debt of CN¥4.22b, up from CN¥3.68b in one year. However, it does have CN¥942.3m in cash offsetting this, leading to net debt of about CN¥3.28b.

A Look At Shanghai Pret Composites' Liabilities

According to the last reported balance sheet, Shanghai Pret Composites had liabilities of CN¥5.78b due within 12 months, and liabilities of CN¥1.08b due beyond 12 months. Offsetting these obligations, it had cash of CN¥942.3m as well as receivables valued at CN¥3.86b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.05b.

Of course, Shanghai Pret Composites has a market capitalization of CN¥12.2b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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

With a net debt to EBITDA ratio of 5.8, it's fair to say Shanghai Pret Composites does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.3 times, suggesting it can responsibly service its obligations. Even worse, Shanghai Pret Composites saw its EBIT tank 49% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Pret Composites 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shanghai Pret Composites burned a lot of cash. 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

On the face of it, Shanghai Pret Composites's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. Overall, it seems to us that Shanghai Pret Composites's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Case in point: We've spotted 3 warning signs for Shanghai Pret Composites you should be aware of, and 1 of them makes us a bit uncomfortable.

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.