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. We note that Shangri-La Asia Limited (HKG:69) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Shangri-La Asia Carry?
The chart below, which you can click on for greater detail, shows that Shangri-La Asia had US$5.30b in debt in June 2019; about the same as the year before. However, it does have US$950.2m in cash offsetting this, leading to net debt of about US$4.35b.
How Healthy Is Shangri-La Asia's Balance Sheet?
According to the last reported balance sheet, Shangri-La Asia had liabilities of US$1.50b due within 12 months, and liabilities of US$5.74b due beyond 12 months. Offsetting these obligations, it had cash of US$950.2m as well as receivables valued at US$333.0m due within 12 months. So it has liabilities totalling US$5.96b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$3.67b 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'd watch its balance sheet closely, without a doubt At the end of the day, Shangri-La Asia would probably need a major re-capitalization if its creditors were to demand repayment.
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 1.8 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in Shangri-La Asia like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On a lighter note, we note that Shangri-La Asia grew its EBIT by 24% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shangri-La Asia 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Shangri-La Asia recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, Shangri-La Asia's net debt to EBITDA 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. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Shangri-La Asia stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Shangri-La Asia insiders have sold any shares recently. You click here to find out if insiders have sold recently.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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