Is Shanghai Aiko Solar EnergyLtd (SHSE:600732) Using Too Much 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.' 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 Aiko Solar Energy Co.,Ltd. (SHSE:600732) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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, 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 Aiko Solar EnergyLtd

How Much Debt Does Shanghai Aiko Solar EnergyLtd Carry?

As you can see below, at the end of September 2023, Shanghai Aiko Solar EnergyLtd had CN¥5.94b of debt, up from CN¥4.72b a year ago. Click the image for more detail. On the flip side, it has CN¥4.94b in cash leading to net debt of about CN¥1.01b.

How Healthy Is Shanghai Aiko Solar EnergyLtd's Balance Sheet?

We can see from the most recent balance sheet that Shanghai Aiko Solar EnergyLtd had liabilities of CN¥15.1b falling due within a year, and liabilities of CN¥8.02b due beyond that. Offsetting these obligations, it had cash of CN¥4.94b as well as receivables valued at CN¥1.33b due within 12 months. So its liabilities total CN¥16.9b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥25.0b, so it does suggest shareholders should keep an eye on Shanghai Aiko Solar EnergyLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Shanghai Aiko Solar EnergyLtd's net debt is only 0.23 times its EBITDA. And its EBIT covers its interest expense a whopping 46.3 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Shanghai Aiko Solar EnergyLtd grew its EBIT by 117% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shanghai Aiko Solar EnergyLtd can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shanghai Aiko Solar EnergyLtd 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

Shanghai Aiko Solar EnergyLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Shanghai Aiko Solar EnergyLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 example Shanghai Aiko Solar EnergyLtd has 2 warning signs (and 1 which is potentially serious) we think you should know about.

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.