Here's Why Shenzhen Best of Best HoldingsLtd (SZSE:001298) Can Manage Its Debt Responsibly

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. As with many other companies Shenzhen Best of Best Holdings Co.,Ltd. (SZSE:001298) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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.

View our latest analysis for Shenzhen Best of Best HoldingsLtd

What Is Shenzhen Best of Best HoldingsLtd's Net Debt?

As you can see below, at the end of June 2024, Shenzhen Best of Best HoldingsLtd had CN¥950.1m of debt, up from CN¥833.2m a year ago. Click the image for more detail. However, it does have CN¥490.0m in cash offsetting this, leading to net debt of about CN¥460.0m.

A Look At Shenzhen Best of Best HoldingsLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that Shenzhen Best of Best HoldingsLtd had liabilities of CN¥1.31b due within 12 months and liabilities of CN¥1.59m due beyond that. On the other hand, it had cash of CN¥490.0m and CN¥1.53b worth of receivables due within a year. So it actually has CN¥706.2m more liquid assets than total liabilities.

This surplus suggests that Shenzhen Best of Best HoldingsLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shenzhen Best of Best HoldingsLtd's debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 3.0 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that Shenzhen Best of Best HoldingsLtd grew its EBIT a smooth 76% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shenzhen Best of Best HoldingsLtd'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 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. During the last three years, Shenzhen Best of Best HoldingsLtd 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

Based on what we've seen Shenzhen Best of Best HoldingsLtd is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. Looking at all this data makes us feel a little cautious about Shenzhen Best of Best HoldingsLtd's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 2 warning signs with Shenzhen Best of Best HoldingsLtd , and understanding them should be part of your investment process.

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.