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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Shanghai Baosteel Packaging Co., Ltd. (SHSE:601968) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shanghai Baosteel Packaging's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shanghai Baosteel Packaging had debt of CN¥1.15b, up from CN¥984.3m in one year. However, it does have CN¥640.6m in cash offsetting this, leading to net debt of about CN¥512.9m.

How Strong Is Shanghai Baosteel Packaging's Balance Sheet?

The latest balance sheet data shows that Shanghai Baosteel Packaging had liabilities of CN¥4.41b due within a year, and liabilities of CN¥551.7m falling due after that. On the other hand, it had cash of CN¥640.6m and CN¥1.81b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.51b.

While this might seem like a lot, it is not so bad since Shanghai Baosteel Packaging has a market capitalization of CN¥5.86b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Shanghai Baosteel Packaging has a low net debt to EBITDA ratio of only 0.72. And its EBIT easily covers its interest expense, being 24.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Shanghai Baosteel Packaging has seen its EBIT plunge 16% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shanghai Baosteel Packaging 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 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. Looking at the most recent three years, Shanghai Baosteel Packaging recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Shanghai Baosteel Packaging's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Shanghai Baosteel Packaging is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 2 warning signs for Shanghai Baosteel Packaging you should be aware of, and 1 of them makes us a bit uncomfortable.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.