Here's Why SHENZHEN TOPRAYSOLARLtd (SZSE:002218) Has A Meaningful Debt Burden

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. We can see that SHENZHEN TOPRAYSOLAR Co.,Ltd. (SZSE:002218) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for SHENZHEN TOPRAYSOLARLtd

What Is SHENZHEN TOPRAYSOLARLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 SHENZHEN TOPRAYSOLARLtd had CN¥1.90b of debt, an increase on CN¥1.64b, over one year. However, it also had CN¥769.9m in cash, and so its net debt is CN¥1.13b.

How Strong Is SHENZHEN TOPRAYSOLARLtd's Balance Sheet?

According to the last reported balance sheet, SHENZHEN TOPRAYSOLARLtd had liabilities of CN¥875.2m due within 12 months, and liabilities of CN¥1.79b due beyond 12 months. On the other hand, it had cash of CN¥769.9m and CN¥1.53b worth of receivables due within a year. So its liabilities total CN¥370.0m more than the combination of its cash and short-term receivables.

Of course, SHENZHEN TOPRAYSOLARLtd has a market capitalization of CN¥4.32b, so these liabilities are probably manageable. 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.

While we wouldn't worry about SHENZHEN TOPRAYSOLARLtd's net debt to EBITDA ratio of 2.8, we think its super-low interest cover of 1.8 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, SHENZHEN TOPRAYSOLARLtd's EBIT was down 27% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SHENZHEN TOPRAYSOLARLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, SHENZHEN TOPRAYSOLARLtd reported free cash flow worth 13% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, SHENZHEN TOPRAYSOLARLtd's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that SHENZHEN TOPRAYSOLARLtd's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example SHENZHEN TOPRAYSOLARLtd has 3 warning signs (and 1 which can't be ignored) 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.