Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Shanghai Lingang Holdings Co.,Ltd. (SHSE:900928) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shanghai Lingang HoldingsLtd

What Is Shanghai Lingang HoldingsLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Shanghai Lingang HoldingsLtd had CN¥26.4b of debt, an increase on CN¥21.1b, over one year. However, it does have CN¥7.46b in cash offsetting this, leading to net debt of about CN¥18.9b.

A Look At Shanghai Lingang HoldingsLtd's Liabilities

According to the last reported balance sheet, Shanghai Lingang HoldingsLtd had liabilities of CN¥27.2b due within 12 months, and liabilities of CN¥17.7b due beyond 12 months. Offsetting these obligations, it had cash of CN¥7.46b as well as receivables valued at CN¥370.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥37.0b.

Given this deficit is actually higher than the company's market capitalization of CN¥27.1b, we think shareholders really should watch Shanghai Lingang HoldingsLtd's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

With a net debt to EBITDA ratio of 7.7, it's fair to say Shanghai Lingang HoldingsLtd does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.1 times, suggesting it can responsibly service its obligations. Shareholders should be aware that Shanghai Lingang HoldingsLtd's EBIT was down 23% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Lingang HoldingsLtd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shanghai Lingang HoldingsLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Shanghai Lingang HoldingsLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We think the chances that Shanghai Lingang HoldingsLtd has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Shanghai Lingang HoldingsLtd you should be aware of, and 1 of them is concerning.

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.

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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.