Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Dazhong Public Utilities(Group) Co.,Ltd. (SHSE:600635) makes use of debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Shanghai Dazhong Public Utilities(Group)Ltd's Debt?

As you can see below, Shanghai Dazhong Public Utilities(Group)Ltd had CN¥8.10b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥3.57b in cash, and so its net debt is CN¥4.53b.

How Strong Is Shanghai Dazhong Public Utilities(Group)Ltd's Balance Sheet?

According to the last reported balance sheet, Shanghai Dazhong Public Utilities(Group)Ltd had liabilities of CN¥8.44b due within 12 months, and liabilities of CN¥4.31b due beyond 12 months. On the other hand, it had cash of CN¥3.57b and CN¥486.1m worth of receivables due within a year. So it has liabilities totalling CN¥8.69b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥10.0b, so it does suggest shareholders should keep an eye on Shanghai Dazhong Public Utilities(Group)Ltd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

As it happens Shanghai Dazhong Public Utilities(Group)Ltd has a fairly concerning net debt to EBITDA ratio of 6.4 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! It is well worth noting that Shanghai Dazhong Public Utilities(Group)Ltd's EBIT shot up like bamboo after rain, gaining 41% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shanghai Dazhong Public Utilities(Group)Ltd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Shanghai Dazhong Public Utilities(Group)Ltd's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Shanghai Dazhong Public Utilities(Group)Ltd's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. It's also worth noting that Shanghai Dazhong Public Utilities(Group)Ltd is in the Gas Utilities industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Shanghai Dazhong Public Utilities(Group)Ltd's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 4 warning signs for Shanghai Dazhong Public Utilities(Group)Ltd you should be aware of, and 3 of them are significant.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.