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. 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 Sichuan Expressway Company Limited (HKG:107) makes use of debt. But is this debt a concern to shareholders?
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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Sichuan Expressway's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Sichuan Expressway had CN¥17.0b of debt in September 2019, down from CN¥17.9b, one year before. However, it also had CN¥4.02b in cash, and so its net debt is CN¥13.0b.
How Strong Is Sichuan Expressway's Balance Sheet?
According to the last reported balance sheet, Sichuan Expressway had liabilities of CN¥4.99b due within 12 months, and liabilities of CN¥16.4b due beyond 12 months. Offsetting this, it had CN¥4.02b in cash and CN¥696.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥16.6b.
The deficiency here weighs heavily on the CN¥10.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. After all, Sichuan Expressway would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Sichuan Expressway's debt is 4.5 times its EBITDA, and its EBIT cover its interest expense 3.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a lighter note, we note that Sichuan Expressway grew its EBIT by 20% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sichuan Expressway'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Sichuan Expressway produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Mulling over Sichuan Expressway's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Infrastructure industry companies like Sichuan Expressway commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Sichuan Expressway stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Sichuan Expressway's dividend history, without delay!
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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