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.' 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 note that Shanghai GenTech Co., Ltd. (SHSE:688596) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Shanghai GenTech's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Shanghai GenTech had debt of CN¥1.11b, up from CN¥745.6m in one year. However, it also had CN¥943.6m in cash, and so its net debt is CN¥168.3m.

How Strong Is Shanghai GenTech's Balance Sheet?

The latest balance sheet data shows that Shanghai GenTech had liabilities of CN¥5.40b due within a year, and liabilities of CN¥499.2m falling due after that. Offsetting this, it had CN¥943.6m in cash and CN¥2.22b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.74b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Shanghai GenTech is worth CN¥10.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Shanghai GenTech has a low net debt to EBITDA ratio of only 0.36. And its EBIT easily covers its interest expense, being 98.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Shanghai GenTech grew its EBIT by 44% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shanghai GenTech'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shanghai GenTech 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

Shanghai GenTech's conversion of EBIT to free cash flow 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. When we consider all the elements mentioned above, it seems to us that Shanghai GenTech is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Shanghai GenTech (1 can't be ignored) you should be aware of.

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.