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. As with many other companies Shanghai Electric Group Co., Ltd. (HKG:2727) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 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, 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.

How Much Debt Does Shanghai Electric Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Shanghai Electric Group had CN¥47.0b of debt, an increase on CN¥39.1b, over one year. However, its balance sheet shows it holds CN¥50.2b in cash, so it actually has CN¥3.20b net cash.

How Strong Is Shanghai Electric Group's Balance Sheet?

We can see from the most recent balance sheet that Shanghai Electric Group had liabilities of CN¥167.7b falling due within a year, and liabilities of CN¥38.6b due beyond that. Offsetting this, it had CN¥50.2b in cash and CN¥95.8b in receivables that were due within 12 months. So it has liabilities totalling CN¥60.3b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥59.2b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Given that Shanghai Electric Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

Although Shanghai Electric Group made a loss at the EBIT level, last year, it was also good to see that it generated CN¥1.4b in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shanghai Electric Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Shanghai Electric Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Shanghai Electric Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Shanghai Electric Group does have more liabilities than liquid assets, it also has net cash of CN¥3.20b. And it impressed us with free cash flow of CN¥3.6b, being 257% of its EBIT. So we don't have any problem with Shanghai Electric Group's use of debt. 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. For example - Shanghai Electric Group has 1 warning sign we think you should be aware of.

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.