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 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. As with many other companies Shanghai Highly (Group) Co., Ltd. (SHSE:600619) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Highly (Group)'s Net Debt?

The image below, which you can click on for greater detail, shows that Shanghai Highly (Group) had debt of CN¥4.25b at the end of September 2024, a reduction from CN¥4.83b over a year. However, it does have CN¥4.21b in cash offsetting this, leading to net debt of about CN¥39.3m.

How Healthy Is Shanghai Highly (Group)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Highly (Group) had liabilities of CN¥13.0b due within 12 months and liabilities of CN¥1.43b due beyond that. Offsetting these obligations, it had cash of CN¥4.21b as well as receivables valued at CN¥6.09b due within 12 months. So it has liabilities totalling CN¥4.12b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Shanghai Highly (Group) has a market capitalization of CN¥10.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. But either way, Shanghai Highly (Group) has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Highly (Group) has a net debt to EBITDA ratio of 0.051, suggesting a very conservative balance sheet. But EBIT was only 2.3 times the interest expense last year, which shows that the debt has negatively impacted the business, by constraining its options (and restricting its free cash flow). We also note that Shanghai Highly (Group) improved its EBIT from a last year's loss to a positive CN¥174m. There's no doubt that we learn most about debt from the balance sheet. But it is Shanghai Highly (Group)'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 company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Shanghai Highly (Group) actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Shanghai Highly (Group)'s conversion of EBIT to free cash flow was a real positive on this analysis, as was its net debt to EBITDA. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. When we consider all the elements mentioned above, it seems to us that Shanghai Highly (Group) is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Shanghai Highly (Group) (of which 2 are concerning!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.