Here's Why Shanghai Electric Group (HKG:2727) Can Manage Its Debt Responsibly

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.' 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 Shanghai Electric Group Co., Ltd. (HKG:2727) makes use of debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shanghai Electric Group

What Is Shanghai Electric Group's Net Debt?

As you can see below, Shanghai Electric Group had CN¥48.3b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds CN¥49.5b in cash, so it actually has CN¥1.27b net cash.

How Healthy Is Shanghai Electric Group's Balance Sheet?

The latest balance sheet data shows that Shanghai Electric Group had liabilities of CN¥167.0b due within a year, and liabilities of CN¥37.7b falling due after that. Offsetting this, it had CN¥49.5b in cash and CN¥92.1b in receivables that were due within 12 months. So it has liabilities totalling CN¥63.0b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥51.7b, we think shareholders really should watch Shanghai Electric Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Shanghai Electric Group boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

It was also good to see that despite losing money on the EBIT line last year, Shanghai Electric Group turned things around in the last 12 months, delivering and EBIT of CN¥2.4b. 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 Electric Group 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Shanghai Electric Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Shanghai Electric Group actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While Shanghai Electric Group does have more liabilities than liquid assets, it also has net cash of CN¥1.27b. The cherry on top was that in converted 332% of that EBIT to free cash flow, bringing in CN¥8.0b. So we are not troubled with Shanghai Electric Group's debt use. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Shanghai Electric Group's earnings per share history for free.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.