Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Shanghai Baosteel Packaging Co., Ltd. (SHSE:601968) makes use of debt. 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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Shanghai Baosteel Packaging Carry?

You can click the graphic below for the historical numbers, but it shows that Shanghai Baosteel Packaging had CN¥915.8m of debt in March 2024, down from CN¥1.00b, one year before. On the flip side, it has CN¥697.2m in cash leading to net debt of about CN¥218.6m.

A Look At Shanghai Baosteel Packaging's Liabilities

We can see from the most recent balance sheet that Shanghai Baosteel Packaging had liabilities of CN¥3.41b falling due within a year, and liabilities of CN¥809.2m due beyond that. On the other hand, it had cash of CN¥697.2m and CN¥1.43b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.09b.

This deficit isn't so bad because Shanghai Baosteel Packaging is worth CN¥6.12b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shanghai Baosteel Packaging's net debt is only 0.30 times its EBITDA. And its EBIT covers its interest expense a whopping 25.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Shanghai Baosteel Packaging grew its EBIT by 4.4% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shanghai Baosteel Packaging'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. Looking at the most recent three years, Shanghai Baosteel Packaging recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Shanghai Baosteel Packaging's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. Considering this range of data points, we think Shanghai Baosteel Packaging is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. We've identified 1 warning sign with Shanghai Baosteel Packaging , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.