Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Shenzhen Cereals Holdings Co.,Ltd (SZSE:000019) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shenzhen Cereals HoldingsLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that Shenzhen Cereals HoldingsLtd had CN¥1.01b of debt in March 2024, down from CN¥1.64b, one year before. However, it does have CN¥240.9m in cash offsetting this, leading to net debt of about CN¥765.9m.

How Strong Is Shenzhen Cereals HoldingsLtd's Balance Sheet?

The latest balance sheet data shows that Shenzhen Cereals HoldingsLtd had liabilities of CN¥2.05b due within a year, and liabilities of CN¥152.0m falling due after that. On the other hand, it had cash of CN¥240.9m and CN¥126.7m worth of receivables due within a year. So its liabilities total CN¥1.83b more than the combination of its cash and short-term receivables.

Shenzhen Cereals HoldingsLtd has a market capitalization of CN¥6.82b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Shenzhen Cereals HoldingsLtd has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 16.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Shenzhen Cereals HoldingsLtd has seen its EBIT plunge 11% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shenzhen Cereals HoldingsLtd'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.

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. Happily for any shareholders, Shenzhen Cereals HoldingsLtd actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that Shenzhen Cereals HoldingsLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Shenzhen Cereals HoldingsLtd can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Shenzhen Cereals HoldingsLtd has 1 warning sign we think 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.