We Think Shanghai Pret Composites (SZSE:002324) Is Taking Some Risk With Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Shanghai Pret Composites Co., Ltd. (SZSE:002324) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

Check out our latest analysis for Shanghai Pret Composites

How Much Debt Does Shanghai Pret Composites Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shanghai Pret Composites had CN¥4.03b of debt, an increase on CN¥3.52b, over one year. However, it also had CN¥1.05b in cash, and so its net debt is CN¥2.98b.

How Healthy Is Shanghai Pret Composites' Balance Sheet?

According to the last reported balance sheet, Shanghai Pret Composites had liabilities of CN¥5.43b due within 12 months, and liabilities of CN¥1.20b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.05b as well as receivables valued at CN¥3.85b due within 12 months. So it has liabilities totalling CN¥1.73b more than its cash and near-term receivables, combined.

Given Shanghai Pret Composites has a market capitalization of CN¥8.86b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Shanghai Pret Composites's debt is 4.5 times its EBITDA, and its EBIT cover its interest expense 4.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Shanghai Pret Composites's EBIT flopped 11% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Pret Composites'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shanghai Pret Composites burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say Shanghai Pret Composites's conversion of EBIT to free cash flow was disappointing. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, we think it's fair to say that Shanghai Pret Composites has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Shanghai Pret Composites (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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.