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.' 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 Shenzhen Investment Holdings Bay Area Development Company Limited (HKG:737) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shenzhen Investment Holdings Bay Area Development's Debt?

As you can see below, Shenzhen Investment Holdings Bay Area Development had CN¥4.11b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥979.4m in cash offsetting this, leading to net debt of about CN¥3.13b.

How Healthy Is Shenzhen Investment Holdings Bay Area Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Investment Holdings Bay Area Development had liabilities of CN¥2.63b due within 12 months and liabilities of CN¥2.37b due beyond that. On the other hand, it had cash of CN¥979.4m and CN¥246.3m worth of receivables due within a year. So it has liabilities totalling CN¥3.77b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥5.38b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Shenzhen Investment Holdings Bay Area Development shareholders face the double whammy of a high net debt to EBITDA ratio (6.4), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. The debt burden here is substantial. The good news is that Shenzhen Investment Holdings Bay Area Development grew its EBIT a smooth 58% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shenzhen Investment Holdings Bay Area Development'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.

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, Shenzhen Investment Holdings Bay Area Development burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Shenzhen Investment Holdings Bay Area Development's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Infrastructure industry companies like Shenzhen Investment Holdings Bay Area Development commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Shenzhen Investment Holdings Bay Area Development's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 3 warning signs we've spotted with Shenzhen Investment Holdings Bay Area Development .

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.