Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Shanghai Waigaoqiao Free Trade Zone Group Co., Ltd. (SHSE:900912) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shanghai Waigaoqiao Free Trade Zone Group

What Is Shanghai Waigaoqiao Free Trade Zone Group's Debt?

As you can see below, Shanghai Waigaoqiao Free Trade Zone Group had CN¥18.5b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥5.94b in cash offsetting this, leading to net debt of about CN¥12.5b.

A Look At Shanghai Waigaoqiao Free Trade Zone Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Shanghai Waigaoqiao Free Trade Zone Group had liabilities of CN¥17.4b due within 12 months and liabilities of CN¥10.7b due beyond that. Offsetting this, it had CN¥5.94b in cash and CN¥1.01b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥21.2b.

This deficit casts a shadow over the CN¥11.4b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Shanghai Waigaoqiao Free Trade Zone Group would probably need a major re-capitalization if its creditors were to demand repayment.

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

As it happens Shanghai Waigaoqiao Free Trade Zone Group has a fairly concerning net debt to EBITDA ratio of 5.8 but very strong interest coverage of 48.0. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Shanghai Waigaoqiao Free Trade Zone Group's EBIT fell a jaw-dropping 35% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Shanghai Waigaoqiao Free Trade Zone Group'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Shanghai Waigaoqiao Free Trade Zone Group produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Shanghai Waigaoqiao Free Trade Zone Group's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider Shanghai Waigaoqiao Free Trade Zone Group to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 instance, we've identified 3 warning signs for Shanghai Waigaoqiao Free Trade Zone Group (2 are a bit unpleasant) you should be aware of.

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.