David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 note that Shanghai Dazhong Public Utilities(Group) Co.,Ltd. (SHSE:600635) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

What Is Shanghai Dazhong Public Utilities(Group)Ltd's Net Debt?

As you can see below, Shanghai Dazhong Public Utilities(Group)Ltd had CN¥8.33b of debt at March 2024, down from CN¥9.85b a year prior. However, because it has a cash reserve of CN¥3.29b, its net debt is less, at about CN¥5.04b.

A Look At Shanghai Dazhong Public Utilities(Group)Ltd's Liabilities

We can see from the most recent balance sheet that Shanghai Dazhong Public Utilities(Group)Ltd had liabilities of CN¥8.18b falling due within a year, and liabilities of CN¥4.99b due beyond that. Offsetting this, it had CN¥3.29b in cash and CN¥625.6m in receivables that were due within 12 months. So it has liabilities totalling CN¥9.25b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥7.26b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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

Strangely Shanghai Dazhong Public Utilities(Group)Ltd has a sky high EBITDA ratio of 7.9, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. It is well worth noting that Shanghai Dazhong Public Utilities(Group)Ltd's EBIT shot up like bamboo after rain, gaining 33% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shanghai Dazhong Public Utilities(Group)Ltd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shanghai Dazhong Public Utilities(Group)Ltd produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Shanghai Dazhong Public Utilities(Group)Ltd's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. It's also worth noting that Shanghai Dazhong Public Utilities(Group)Ltd is in the Gas Utilities industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Shanghai Dazhong Public Utilities(Group)Ltd is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. 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 Dazhong Public Utilities(Group)Ltd you should know about.

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.