Is Shennan Circuit (SZSE:002916) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Shennan Circuit Company Limited (SZSE:002916) does use debt in its business. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shennan Circuit

What Is Shennan Circuit's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shennan Circuit had CN¥3.27b of debt, an increase on CN¥2.04b, over one year. However, it does have CN¥1.45b in cash offsetting this, leading to net debt of about CN¥1.82b.

How Healthy Is Shennan Circuit's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shennan Circuit had liabilities of CN¥6.65b due within 12 months and liabilities of CN¥3.12b due beyond that. On the other hand, it had cash of CN¥1.45b and CN¥4.36b worth of receivables due within a year. So its liabilities total CN¥3.97b more than the combination of its cash and short-term receivables.

Given Shennan Circuit has a market capitalization of CN¥47.3b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). 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).

Shennan Circuit's net debt is only 0.79 times its EBITDA. And its EBIT covers its interest expense a whopping 19.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Shennan Circuit's load is not too heavy, because its EBIT was down 24% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shennan Circuit's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. During the last three years, Shennan Circuit burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Shennan Circuit's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Shennan Circuit is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Shennan Circuit .

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.