Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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.

Check out our latest analysis for Shanghai Lujiazui Finance & Trade Zone Development

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

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Shanghai Lujiazui Finance & Trade Zone Development had CN¥57.4b of debt, an increase on CN¥48.6b, over one year. However, it also had CN¥12.5b in cash, and so its net debt is CN¥45.0b.

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¥45.8b due within 12 months and liabilities of CN¥36.4b due beyond that. Offsetting this, it had CN¥12.5b in cash and CN¥4.77b in receivables that were due within 12 months. So it has liabilities totalling CN¥65.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥35.2b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Shanghai Lujiazui Finance & Trade Zone Development would likely require a major re-capitalisation if it had to pay its creditors today.

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).

With a net debt to EBITDA ratio of 5.8, it's fair to say Shanghai Lujiazui Finance & Trade Zone Development does have a significant amount of debt. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Unfortunately, Shanghai Lujiazui Finance & Trade Zone Development saw its EBIT slide 5.5% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shanghai Lujiazui Finance & Trade Zone Development'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shanghai Lujiazui Finance & Trade Zone Development 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

On the face of it, Shanghai Lujiazui Finance & Trade Zone Development's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. After considering the datapoints discussed, we think Shanghai Lujiazui Finance & Trade Zone Development has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Shanghai Lujiazui Finance & Trade Zone Development (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.