Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Shanghai Lujiazui Finance & Trade Zone Development Co., Ltd. (SHSE:600663) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Shanghai Lujiazui Finance & Trade Zone Development

What Is Shanghai Lujiazui Finance & Trade Zone Development's Net Debt?

As you can see below, at the end of September 2022, Shanghai Lujiazui Finance & Trade Zone Development had CN¥60.5b of debt, up from CN¥50.8b a year ago. Click the image for more detail. However, it does have CN¥9.05b in cash offsetting this, leading to net debt of about CN¥51.4b.

How Strong Is Shanghai Lujiazui Finance & Trade Zone Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Lujiazui Finance & Trade Zone Development had liabilities of CN¥48.1b due within 12 months and liabilities of CN¥38.2b due beyond that. Offsetting these obligations, it had cash of CN¥9.05b as well as receivables valued at CN¥2.33b due within 12 months. So it has liabilities totalling CN¥74.9b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥33.0b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Shanghai Lujiazui Finance & Trade Zone Development would probably need a major re-capitalization if its creditors were to demand repayment.

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 Lujiazui Finance & Trade Zone Development has a rather high debt to EBITDA ratio of 7.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.6 times, suggesting it can responsibly service its obligations. The bad news is that Shanghai Lujiazui Finance & Trade Zone Development saw its EBIT decline by 16% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 Lujiazui Finance & Trade Zone Development 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shanghai Lujiazui Finance & Trade Zone Development saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Shanghai Lujiazui Finance & Trade Zone Development's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We think the chances that Shanghai Lujiazui Finance & Trade Zone Development has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. For example, we've discovered 2 warning signs for Shanghai Lujiazui Finance & Trade Zone Development (1 is significant!) that you should be aware of before investing here.

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.