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.' 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 Shanghai Dazhong Public Utilities(Group) Co.,Ltd. (SHSE:600635) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 Shanghai Dazhong Public Utilities(Group)Ltd's Debt?

You can click the graphic below for the historical numbers, but it shows that Shanghai Dazhong Public Utilities(Group)Ltd had CN¥8.28b of debt in June 2024, down from CN¥8.94b, one year before. However, it also had CN¥4.09b in cash, and so its net debt is CN¥4.19b.

How Healthy Is Shanghai Dazhong Public Utilities(Group)Ltd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Dazhong Public Utilities(Group)Ltd had liabilities of CN¥7.98b due within 12 months and liabilities of CN¥5.07b due beyond that. On the other hand, it had cash of CN¥4.09b and CN¥1.44b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥7.52b.

This is a mountain of leverage relative to its market capitalization of CN¥7.86b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

As it happens Shanghai Dazhong Public Utilities(Group)Ltd has a fairly concerning net debt to EBITDA ratio of 6.6 but very strong interest coverage of 16.5. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably Shanghai Dazhong Public Utilities(Group)Ltd's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. 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 always check how much of that EBIT is translated into free cash flow. During the last three years, Shanghai Dazhong Public Utilities(Group)Ltd produced sturdy free cash flow equating to 62% 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 and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We should also note that Gas Utilities industry companies like Shanghai Dazhong Public Utilities(Group)Ltd commonly do use debt without problems. We think that Shanghai Dazhong Public Utilities(Group)Ltd's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. To that end, you should learn about the 4 warning signs we've spotted with Shanghai Dazhong Public Utilities(Group)Ltd (including 3 which are a bit unpleasant) .

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.

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