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. We can see that Shenzhen SDG Information Co., Ltd. (SZSE:000070) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shenzhen SDG Information's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shenzhen SDG Information had CN¥3.12b of debt, an increase on CN¥2.80b, over one year. However, it does have CN¥685.0m in cash offsetting this, leading to net debt of about CN¥2.43b.

How Healthy Is Shenzhen SDG Information's Balance Sheet?

The latest balance sheet data shows that Shenzhen SDG Information had liabilities of CN¥3.57b due within a year, and liabilities of CN¥2.24b falling due after that. On the other hand, it had cash of CN¥685.0m and CN¥2.55b worth of receivables due within a year. So it has liabilities totalling CN¥2.58b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥4.04b, so it does suggest shareholders should keep an eye on Shenzhen SDG Information's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).

Shenzhen SDG Information shareholders face the double whammy of a high net debt to EBITDA ratio (15.5), and fairly weak interest coverage, since EBIT is just 0.23 times the interest expense. The debt burden here is substantial. One redeeming factor for Shenzhen SDG Information is that it turned last year's EBIT loss into a gain of CN¥10m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shenzhen SDG Information's earnings that will influence how the balance sheet holds up in the future. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Shenzhen SDG Information actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Shenzhen SDG Information's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Shenzhen SDG Information is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Shenzhen SDG Information , 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.

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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.