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. Importantly, Shanghai Shibei Hi-Tech Co.,Ltd. (SHSE:600604) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shanghai Shibei Hi-TechLtd

How Much Debt Does Shanghai Shibei Hi-TechLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Shanghai Shibei Hi-TechLtd had CN¥9.81b of debt, an increase on CN¥8.96b, over one year. However, because it has a cash reserve of CN¥692.0m, its net debt is less, at about CN¥9.12b.

How Strong Is Shanghai Shibei Hi-TechLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Shibei Hi-TechLtd had liabilities of CN¥5.19b due within 12 months and liabilities of CN¥7.06b due beyond that. Offsetting this, it had CN¥692.0m in cash and CN¥476.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥11.1b.

Given this deficit is actually higher than the company's market capitalization of CN¥9.04b, we think shareholders really should watch Shanghai Shibei Hi-TechLtd's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.

Weak interest cover of 1.6 times and a disturbingly high net debt to EBITDA ratio of 11.1 hit our confidence in Shanghai Shibei Hi-TechLtd like a one-two punch to the gut. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Shanghai Shibei Hi-TechLtd actually grew its EBIT by a hefty 216%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shanghai Shibei Hi-TechLtd will need earnings to service that debt. 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. Over the last three years, Shanghai Shibei Hi-TechLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Shanghai Shibei Hi-TechLtd's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Shanghai Shibei Hi-TechLtd 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. 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. We've identified 3 warning signs with Shanghai Shibei Hi-TechLtd (at least 2 which are significant) , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.