The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Shanghai STEP Electric Corporation (SZSE:002527) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

What Is Shanghai STEP Electric's Debt?

As you can see below, Shanghai STEP Electric had CN¥1.34b 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¥572.1m in cash, and so its net debt is CN¥769.5m.

How Healthy Is Shanghai STEP Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai STEP Electric had liabilities of CN¥2.64b due within 12 months and liabilities of CN¥390.0m due beyond that. Offsetting these obligations, it had cash of CN¥572.1m as well as receivables valued at CN¥1.59b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥866.7m.

Since publicly traded Shanghai STEP Electric shares are worth a total of CN¥4.72b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shanghai STEP Electric's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Shanghai STEP Electric had a loss before interest and tax, and actually shrunk its revenue by 6.3%, to CN¥3.1b. That's not what we would hope to see.

Caveat Emptor

Over the last twelve months Shanghai STEP Electric produced an earnings before interest and tax (EBIT) loss. To be specific the EBIT loss came in at CN¥198m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of CN¥501m into a profit. So we do think this stock is quite risky. 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. Case in point: We've spotted 1 warning sign for Shanghai STEP Electric you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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.