Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 can see that Shanghai Putailai New Energy Technology Co.,Ltd. (SHSE:603659) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shanghai Putailai New Energy TechnologyLtd's Net Debt?

As you can see below, at the end of March 2024, Shanghai Putailai New Energy TechnologyLtd had CN¥10.1b of debt, up from CN¥6.95b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥8.28b, its net debt is less, at about CN¥1.78b.

How Healthy Is Shanghai Putailai New Energy TechnologyLtd's Balance Sheet?

The latest balance sheet data shows that Shanghai Putailai New Energy TechnologyLtd had liabilities of CN¥17.5b due within a year, and liabilities of CN¥5.13b falling due after that. Offsetting these obligations, it had cash of CN¥8.28b as well as receivables valued at CN¥5.42b due within 12 months. So it has liabilities totalling CN¥8.93b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Shanghai Putailai New Energy TechnologyLtd is worth CN¥35.1b, and thus could probably raise enough capital to shore up 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.

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 Putailai New Energy TechnologyLtd's net debt is only 0.69 times its EBITDA. And its EBIT easily covers its interest expense, being 44.4 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Shanghai Putailai New Energy TechnologyLtd if management cannot prevent a repeat of the 47% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Putailai New Energy TechnologyLtd'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 Putailai New Energy TechnologyLtd 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 Putailai New Energy TechnologyLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Shanghai Putailai New Energy TechnologyLtd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Shanghai Putailai New Energy TechnologyLtd (of which 1 is potentially serious!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.