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.' 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. Importantly, Shanghai Shibei Hi-Tech Co.,Ltd. (SHSE:600604) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Shanghai Shibei Hi-TechLtd

What Is Shanghai Shibei Hi-TechLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shanghai Shibei Hi-TechLtd had CN¥8.72b of debt in September 2023, down from CN¥9.94b, one year before. However, it does have CN¥1.64b in cash offsetting this, leading to net debt of about CN¥7.08b.

A Look At Shanghai Shibei Hi-TechLtd's Liabilities

The latest balance sheet data shows that Shanghai Shibei Hi-TechLtd had liabilities of CN¥7.32b due within a year, and liabilities of CN¥6.29b falling due after that. Offsetting these obligations, it had cash of CN¥1.64b as well as receivables valued at CN¥159.6m due within 12 months. So its liabilities total CN¥11.8b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥7.21b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Shanghai Shibei Hi-TechLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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

Strangely Shanghai Shibei Hi-TechLtd has a sky high EBITDA ratio of 11.4, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that Shanghai Shibei Hi-TechLtd's EBIT was down 51% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Shibei Hi-TechLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shanghai Shibei Hi-TechLtd recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

On the face of it, Shanghai Shibei Hi-TechLtd's EBIT growth rate 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. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Shanghai Shibei Hi-TechLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Shanghai Shibei Hi-TechLtd (1 makes us a bit uncomfortable) you should be aware of.

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.