We Think Shennan Circuit (SZSE:002916) Can Stay On Top Of Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Shennan Circuit Company Limited (SZSE:002916) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shennan Circuit

What Is Shennan Circuit's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shennan Circuit had debt of CN¥3.29b, up from CN¥2.91b in one year. However, because it has a cash reserve of CN¥957.5m, its net debt is less, at about CN¥2.33b.

A Look At Shennan Circuit's Liabilities

We can see from the most recent balance sheet that Shennan Circuit had liabilities of CN¥7.56b falling due within a year, and liabilities of CN¥2.96b due beyond that. Offsetting this, it had CN¥957.5m in cash and CN¥5.18b in receivables that were due within 12 months. So its liabilities total CN¥4.39b more than the combination of its cash and short-term receivables.

Since publicly traded Shennan Circuit shares are worth a total of CN¥65.2b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shennan Circuit's net debt is only 0.75 times its EBITDA. And its EBIT covers its interest expense a whopping 29.0 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Shennan Circuit has boosted its EBIT by 52%, thus reducing the spectre of future debt repayments. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shennan Circuit recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Happily, Shennan Circuit's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Shennan Circuit is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Shennan Circuit is showing 3 warning signs in our investment analysis , you should know about...

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.