These 4 Measures Indicate That Shanghai Shibei Hi-TechLtd (SHSE:600604) Is Using Debt Extensively

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Shanghai Shibei Hi-Tech Co.,Ltd. (SHSE:600604) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shanghai Shibei Hi-TechLtd

What Is Shanghai Shibei Hi-TechLtd's Debt?

As you can see below, Shanghai Shibei Hi-TechLtd had CN¥8.72b of debt at September 2023, down from CN¥9.94b a year prior. However, it also had CN¥1.64b in cash, and so its net debt is CN¥7.08b.

A Look At Shanghai Shibei Hi-TechLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Shanghai Shibei Hi-TechLtd had liabilities of CN¥7.32b due within 12 months and liabilities of CN¥6.29b due beyond that. Offsetting these obligations, it had cash of CN¥1.64b as well as receivables valued at CN¥159.6m due within 12 months. So it has liabilities totalling CN¥11.8b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥6.38b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Shanghai Shibei Hi-TechLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Shanghai Shibei Hi-TechLtd has a sky high EBITDA ratio of 11.4, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Shanghai Shibei Hi-TechLtd's EBIT fell a jaw-dropping 51% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shanghai Shibei Hi-TechLtd's earnings that will influence how the balance sheet holds up in the future. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shanghai Shibei Hi-TechLtd recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

On the face of it, Shanghai Shibei Hi-TechLtd's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Shanghai Shibei Hi-TechLtd's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 4 warning signs for Shanghai Shibei Hi-TechLtd (1 doesn't sit too well with us) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.