Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Titan Scientific Co., Ltd. (SHSE:688133) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shanghai Titan Scientific's Net Debt?

As you can see below, at the end of September 2024, Shanghai Titan Scientific had CN¥1.47b of debt, up from CN¥976.2m a year ago. Click the image for more detail. However, it does have CN¥978.4m in cash offsetting this, leading to net debt of about CN¥496.4m.

A Look At Shanghai Titan Scientific's Liabilities

The latest balance sheet data shows that Shanghai Titan Scientific had liabilities of CN¥1.52b due within a year, and liabilities of CN¥460.4m falling due after that. On the other hand, it had cash of CN¥978.4m and CN¥938.1m worth of receivables due within a year. So it has liabilities totalling CN¥68.3m more than its cash and near-term receivables, combined.

Having regard to Shanghai Titan Scientific's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥3.66b company is struggling for cash, we still think it's worth monitoring its balance sheet.

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 0.70 times and a disturbingly high net debt to EBITDA ratio of 9.8 hit our confidence in Shanghai Titan Scientific like a one-two punch to the gut. The debt burden here is substantial. Even worse, Shanghai Titan Scientific saw its EBIT tank 85% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shanghai Titan Scientific can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shanghai Titan Scientific saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Shanghai Titan Scientific's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. We're quite clear that we consider Shanghai Titan Scientific to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that Shanghai Titan Scientific is showing 3 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.