Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Shijiazhuang Shangtai Technology Co., Ltd. (SZSE:001301) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shijiazhuang Shangtai Technology

What Is Shijiazhuang Shangtai Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that Shijiazhuang Shangtai Technology had CN¥1.03b of debt in September 2023, down from CN¥1.24b, one year before. However, it also had CN¥709.7m in cash, and so its net debt is CN¥319.3m.

How Strong Is Shijiazhuang Shangtai Technology's Balance Sheet?

According to the last reported balance sheet, Shijiazhuang Shangtai Technology had liabilities of CN¥1.83b due within 12 months, and liabilities of CN¥590.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥709.7m as well as receivables valued at CN¥2.80b due within 12 months. So it can boast CN¥1.09b more liquid assets than total liabilities.

This surplus suggests that Shijiazhuang Shangtai Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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

Shijiazhuang Shangtai Technology's net debt is only 0.25 times its EBITDA. And its EBIT easily covers its interest expense, being 21.5 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Shijiazhuang Shangtai Technology's load is not too heavy, because its EBIT was down 37% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shijiazhuang Shangtai Technology'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. Over the last three years, Shijiazhuang Shangtai Technology 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

We feel some trepidation about Shijiazhuang Shangtai Technology's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Shijiazhuang Shangtai Technology's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Shijiazhuang Shangtai Technology is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.