Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Shenzhen International Holdings Limited (HKG:152) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
How Much Debt Does Shenzhen International Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Shenzhen International Holdings had debt of HK$26.7b, up from HK$23.8b in one year. However, it also had HK$15.0b in cash, and so its net debt is HK$11.8b.
How Strong Is Shenzhen International Holdings's Balance Sheet?
According to the last reported balance sheet, Shenzhen International Holdings had liabilities of HK$14.9b due within 12 months, and liabilities of HK$27.8b due beyond 12 months. On the other hand, it had cash of HK$15.0b and HK$2.61b worth of receivables due within a year. So it has liabilities totalling HK$25.1b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of HK$34.3b, so it does suggest shareholders should keep an eye on Shenzhen International Holdings's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Shenzhen International Holdings's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 3.4 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Sadly, Shenzhen International Holdings's EBIT actually dropped 4.3% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 International Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shenzhen International Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Mulling over Shenzhen International Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its net debt to EBITDA is not so bad. We should also note that Infrastructure industry companies like Shenzhen International Holdings commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Shenzhen International Holdings's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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