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 New Energy Group Limited (HKG:1250) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Shandong Hi-Speed New Energy Group's Net Debt?

As you can see below, Shandong Hi-Speed New Energy Group had HK$27.8b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of HK$5.43b, its net debt is less, at about HK$22.4b.

A Look At Shandong Hi-Speed New Energy Group's Liabilities

We can see from the most recent balance sheet that Shandong Hi-Speed New Energy Group had liabilities of HK$12.0b falling due within a year, and liabilities of HK$23.4b due beyond that. Offsetting these obligations, it had cash of HK$5.43b as well as receivables valued at HK$10.3b due within 12 months. So its liabilities total HK$19.7b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$3.84b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Shandong Hi-Speed New Energy Group would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 6.3 hit our confidence in Shandong Hi-Speed New Energy Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Given the debt load, it's hardly ideal that Shandong Hi-Speed New Energy Group's EBIT was pretty flat over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shandong Hi-Speed New Energy Group will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shandong Hi-Speed New Energy Group produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Shandong Hi-Speed New Energy Group'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 on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Shandong Hi-Speed New Energy Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example, we've discovered 3 warning signs for Shandong Hi-Speed New Energy Group (2 are a bit unpleasant!) that you should be aware of before investing here.

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.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com