Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies South China Holdings Company Limited (HKG:413) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is South China Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2018 South China Holdings had debt of HK$4.78b, up from HK$4.32b in one year. However, because it has a cash reserve of HK$863.6m, its net debt is less, at about HK$3.92b.
How Strong Is South China Holdings's Balance Sheet?
We can see from the most recent balance sheet that South China Holdings had liabilities of HK$4.13b falling due within a year, and liabilities of HK$3.46b due beyond that. Offsetting these obligations, it had cash of HK$863.6m as well as receivables valued at HK$687.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$6.04b.
This deficit casts a shadow over the HK$2.84b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, South China Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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.
South China Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (53.2), and fairly weak interest coverage, since EBIT is just 0.15 times the interest expense. This means we'd consider it to have a heavy debt load. Another concern for investors might be that South China Holdings's EBIT fell 17% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But it is South China Holdings's earnings that will influence how the balance sheet holds up in the future. 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.
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. During the last three years, South China Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, South China Holdings's conversion of EBIT to free cash flow 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. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that South China Holdings is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. Given the risks around South China Holdings's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.