The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Shanghai Dazhong Public Utilities(Group) Co.,Ltd. (SHSE:600635) makes use of debt. But should shareholders be worried about its use of debt?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Shanghai Dazhong Public Utilities(Group)Ltd

What Is Shanghai Dazhong Public Utilities(Group)Ltd's Debt?

You can click the graphic below for the historical numbers, but it shows that Shanghai Dazhong Public Utilities(Group)Ltd had CN¥8.85b of debt in June 2022, down from CN¥9.77b, one year before. However, because it has a cash reserve of CN¥8.19b, its net debt is less, at about CN¥660.3m.

How Strong Is Shanghai Dazhong Public Utilities(Group)Ltd's Balance Sheet?

The latest balance sheet data shows that Shanghai Dazhong Public Utilities(Group)Ltd had liabilities of CN¥9.34b due within a year, and liabilities of CN¥4.76b falling due after that. On the other hand, it had cash of CN¥8.19b and CN¥1.13b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.78b.

Shanghai Dazhong Public Utilities(Group)Ltd has a market capitalization of CN¥8.46b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Dazhong Public Utilities(Group)Ltd has net debt of just 1.0 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. Also positive, Shanghai Dazhong Public Utilities(Group)Ltd grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 Dazhong Public Utilities(Group)Ltd 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, 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 Dazhong Public Utilities(Group)Ltd 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

Based on what we've seen Shanghai Dazhong Public Utilities(Group)Ltd is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. It's also worth noting that Shanghai Dazhong Public Utilities(Group)Ltd is in the Gas Utilities industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Shanghai Dazhong Public Utilities(Group)Ltd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 Dazhong Public Utilities(Group)Ltd is showing 2 warning signs in our investment analysis , and 1 of those is significant...

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.