The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Shanxi Hi-speed Group Co., Ltd. (SZSE:000755) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Shanxi Hi-speed Group's Net Debt?

As you can see below, Shanxi Hi-speed Group had CN¥6.94b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥1.01b in cash offsetting this, leading to net debt of about CN¥5.93b.

How Healthy Is Shanxi Hi-speed Group's Balance Sheet?

The latest balance sheet data shows that Shanxi Hi-speed Group had liabilities of CN¥1.08b due within a year, and liabilities of CN¥6.67b falling due after that. Offsetting these obligations, it had cash of CN¥1.01b as well as receivables valued at CN¥102.3m due within 12 months. So it has liabilities totalling CN¥6.64b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥6.66b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

Shanxi Hi-speed Group's debt is 4.3 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Investors should also be troubled by the fact that Shanxi Hi-speed Group saw its EBIT drop by 11% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shanxi Hi-speed 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Shanxi Hi-speed Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither Shanxi Hi-speed Group's ability handle its debt, based on its EBITDA, nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We should also note that Infrastructure industry companies like Shanxi Hi-speed Group commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Shanxi Hi-speed Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Shanxi Hi-speed Group has 2 warning signs (and 1 which doesn't sit too well with us) we think 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.

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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.