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, Shenzhen Gas Corporation Ltd. (SHSE:601139) does carry 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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Shenzhen Gas's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Shenzhen Gas had debt of CN¥17.3b, up from CN¥12.3b in one year. On the flip side, it has CN¥6.35b in cash leading to net debt of about CN¥10.9b.

How Strong Is Shenzhen Gas' Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Gas had liabilities of CN¥22.3b falling due within a year, and liabilities of CN¥5.22b due beyond that. Offsetting these obligations, it had cash of CN¥6.35b as well as receivables valued at CN¥5.57b due within 12 months. So its liabilities total CN¥15.6b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥20.9b, so it does suggest shareholders should keep an eye on Shenzhen Gas' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 Gas's net debt is 3.6 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 30.6 is very high, suggesting that the interest expense on the debt is currently quite low. One way Shenzhen Gas could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. 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 Shenzhen Gas's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shenzhen Gas 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

Shenzhen Gas's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We should also note that Gas Utilities industry companies like Shenzhen Gas commonly do use debt without problems. Taking the abovementioned factors together we do think Shenzhen Gas's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 2 warning signs for Shenzhen Gas (1 doesn't sit too well with us!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.