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.' 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. Importantly, Shanghai Dragon Corporation (SHSE:600630) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Shanghai Dragon's Net Debt?

The image below, which you can click on for greater detail, shows that Shanghai Dragon had debt of CN¥404.2m at the end of September 2024, a reduction from CN¥472.3m over a year. However, because it has a cash reserve of CN¥383.9m, its net debt is less, at about CN¥20.3m.

How Healthy Is Shanghai Dragon's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Dragon had liabilities of CN¥784.6m due within 12 months and liabilities of CN¥101.0m due beyond that. Offsetting this, it had CN¥383.9m in cash and CN¥288.7m in receivables that were due within 12 months. So its liabilities total CN¥213.0m more than the combination of its cash and short-term receivables.

Since publicly traded Shanghai Dragon shares are worth a total of CN¥4.69b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Carrying virtually no net debt, Shanghai Dragon has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Shanghai Dragon's low debt to EBITDA ratio of 0.33 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.0 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, Shanghai Dragon made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥37m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shanghai Dragon will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Shanghai Dragon actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Shanghai Dragon's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its interest cover does undermine this impression a bit. When we consider the range of factors above, it looks like Shanghai Dragon is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Shanghai Dragon is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.