Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Shenzhen Investment Holdings Bay Area Development Company Limited (HKG:737) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does Shenzhen Investment Holdings Bay Area Development Carry?

As you can see below, Shenzhen Investment Holdings Bay Area Development had CN¥4.03b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥1.01b in cash offsetting this, leading to net debt of about CN¥3.02b.

How Healthy Is Shenzhen Investment Holdings Bay Area Development's Balance Sheet?

According to the last reported balance sheet, Shenzhen Investment Holdings Bay Area Development had liabilities of CN¥2.33b due within 12 months, and liabilities of CN¥2.38b due beyond 12 months. Offsetting this, it had CN¥1.01b in cash and CN¥168.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥3.53b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥4.99b, so it does suggest shareholders should keep an eye on Shenzhen Investment Holdings Bay Area Development's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 7.4 hit our confidence in Shenzhen Investment Holdings Bay Area Development like a one-two punch to the gut. The debt burden here is substantial. The silver lining is that Shenzhen Investment Holdings Bay Area Development grew its EBIT by 104% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Shenzhen Investment Holdings Bay Area 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 always check how much of that EBIT is translated into free cash flow. During the last three years, Shenzhen Investment Holdings Bay Area 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, Shenzhen Investment Holdings Bay Area Development's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It's also worth noting that Shenzhen Investment Holdings Bay Area Development is in the Infrastructure industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Shenzhen Investment Holdings Bay Area Development's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 2 warning signs we've spotted with Shenzhen Investment Holdings Bay Area Development (including 1 which is significant) .

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.