Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 note that Shandong Hi-speed Company Limited (SHSE:600350) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shandong Hi-speed's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shandong Hi-speed had debt of CN¥74.0b, up from CN¥67.3b in one year. However, because it has a cash reserve of CN¥6.51b, its net debt is less, at about CN¥67.5b.

How Strong Is Shandong Hi-speed's Balance Sheet?

According to the last reported balance sheet, Shandong Hi-speed had liabilities of CN¥33.4b due within 12 months, and liabilities of CN¥68.2b due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.51b as well as receivables valued at CN¥13.1b due within 12 months. So its liabilities total CN¥81.9b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥49.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Shandong Hi-speed would probably need a major re-capitalization if its creditors were to demand repayment.

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.

As it happens Shandong Hi-speed has a fairly concerning net debt to EBITDA ratio of 7.0 but very strong interest coverage of 19.1. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Sadly, Shandong Hi-speed's EBIT actually dropped 9.9% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shandong Hi-speed'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. Considering the last three years, Shandong Hi-speed actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Shandong Hi-speed's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Shandong Hi-speed is in the Infrastructure industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Shandong Hi-speed has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Shandong Hi-speed (1 is potentially serious) you should be aware of.

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.