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 Lujiazui Finance & Trade Zone Development Co.,Ltd. (SHSE:600663) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 Lujiazui Finance & Trade Zone DevelopmentLtd's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd had debt of CN¥67.7b, up from CN¥60.1b in one year. However, because it has a cash reserve of CN¥8.30b, its net debt is less, at about CN¥59.4b.

A Look At Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's Liabilities

The latest balance sheet data shows that Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd had liabilities of CN¥75.3b due within a year, and liabilities of CN¥32.8b falling due after that. Offsetting this, it had CN¥8.30b in cash and CN¥2.73b in receivables that were due within 12 months. So it has liabilities totalling CN¥97.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥37.0b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd has a rather high debt to EBITDA ratio of 12.0 which suggests a meaningful debt load. However, its interest coverage of 3.2 is reasonably strong, which is a good sign. On a lighter note, we note that Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd grew its EBIT by 25% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd can strengthen its balance sheet over time. 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 Lujiazui Finance & Trade Zone DevelopmentLtd reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd has 4 warning signs (and 2 which shouldn't be ignored) we think 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.

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