Does Shenzhen Senior Technology Material (SZSE:300568) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Shenzhen Senior Technology Material Co., Ltd. (SZSE:300568) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Shenzhen Senior Technology Material

What Is Shenzhen Senior Technology Material's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shenzhen Senior Technology Material had debt of CN¥8.48b, up from CN¥5.08b in one year. However, because it has a cash reserve of CN¥4.53b, its net debt is less, at about CN¥3.94b.

A Look At Shenzhen Senior Technology Material's Liabilities

We can see from the most recent balance sheet that Shenzhen Senior Technology Material had liabilities of CN¥4.32b falling due within a year, and liabilities of CN¥6.51b due beyond that. Offsetting these obligations, it had cash of CN¥4.53b as well as receivables valued at CN¥2.28b due within 12 months. So its liabilities total CN¥4.02b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shenzhen Senior Technology Material has a market capitalization of CN¥12.8b, 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.

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.

Shenzhen Senior Technology Material has net debt to EBITDA of 4.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.0 times its interest expense, and its net debt to EBITDA, was quite high, at 4.7. Shareholders should be aware that Shenzhen Senior Technology Material's EBIT was down 59% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shenzhen Senior Technology Material'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, 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. Over the last three years, Shenzhen Senior Technology Material saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Shenzhen Senior Technology Material's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Shenzhen Senior Technology Material'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. We've identified 3 warning signs with Shenzhen Senior Technology Material (at least 2 which can't be ignored) , and understanding them should be part of your investment process.

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.