We Think Shijihengtong Technology (SZSE:301428) 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, Shijihengtong Technology Co., Ltd. (SZSE:301428) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Shijihengtong Technology

What Is Shijihengtong Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Shijihengtong Technology had CN¥644.4m of debt, an increase on CN¥410.7m, over one year. However, it also had CN¥232.2m in cash, and so its net debt is CN¥412.1m.

How Strong Is Shijihengtong Technology's Balance Sheet?

The latest balance sheet data shows that Shijihengtong Technology had liabilities of CN¥683.5m due within a year, and liabilities of CN¥155.8m falling due after that. On the other hand, it had cash of CN¥232.2m and CN¥403.3m worth of receivables due within a year. So it has liabilities totalling CN¥203.8m more than its cash and near-term receivables, combined.

Of course, Shijihengtong Technology has a market capitalization of CN¥4.15b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt to EBITDA of 4.7 Shijihengtong Technology has a fairly noticeable amount of debt. But the high interest coverage of 7.9 suggests it can easily service that debt. Sadly, Shijihengtong Technology's EBIT actually dropped 7.7% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shijihengtong Technology will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shijihengtong Technology 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

Shijihengtong Technology's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. Taking the abovementioned factors together we do think Shijihengtong Technology's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Shijihengtong Technology is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.