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.' 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 can see that Shanghai Bairun Investment Holding Group Co., Ltd. (SZSE:002568) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shanghai Bairun Investment Holding Group's Debt?

As you can see below, at the end of September 2024, Shanghai Bairun Investment Holding Group had CN¥2.29b of debt, up from CN¥2.19b a year ago. Click the image for more detail. However, it does have CN¥1.99b in cash offsetting this, leading to net debt of about CN¥298.2m.

A Look At Shanghai Bairun Investment Holding Group's Liabilities

The latest balance sheet data shows that Shanghai Bairun Investment Holding Group had liabilities of CN¥2.08b due within a year, and liabilities of CN¥1.30b falling due after that. Offsetting these obligations, it had cash of CN¥1.99b as well as receivables valued at CN¥335.4m due within 12 months. So it has liabilities totalling CN¥1.05b more than its cash and near-term receivables, combined.

Given Shanghai Bairun Investment Holding Group has a market capitalization of CN¥24.2b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Shanghai Bairun Investment Holding Group has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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

Shanghai Bairun Investment Holding Group has a low net debt to EBITDA ratio of only 0.27. And its EBIT covers its interest expense a whopping 48.9 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Shanghai Bairun Investment Holding Group has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Shanghai Bairun Investment Holding Group'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.

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. Over the last three years, Shanghai Bairun Investment Holding Group reported free cash flow worth 2.1% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both Shanghai Bairun Investment Holding Group's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Looking at all this data makes us feel a little cautious about Shanghai Bairun Investment Holding Group's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 example, we've discovered 1 warning sign for Shanghai Bairun Investment Holding Group that you should be aware of before investing here.

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.