David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Xinyi Solar Holdings Limited (HKG:968) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Xinyi Solar Holdings's Debt?
As you can see below, at the end of December 2018, Xinyi Solar Holdings had HK$8.77b of debt, up from HK$7.93b a year ago. Click the image for more detail. On the flip side, it has HK$981.3m in cash leading to net debt of about HK$7.79b.
How Healthy Is Xinyi Solar Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Xinyi Solar Holdings had liabilities of HK$6.74b due within 12 months and liabilities of HK$5.10b due beyond that. Offsetting this, it had HK$981.3m in cash and HK$5.19b in receivables that were due within 12 months. So its liabilities total HK$5.67b more than the combination of its cash and short-term receivables.
Given Xinyi Solar Holdings has a market capitalization of HK$34.6b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). 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).
Xinyi Solar Holdings's net debt of 2.5 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 9.9 times its interest expenses harmonizes with that theme. Unfortunately, Xinyi Solar Holdings's EBIT flopped 16% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Xinyi Solar Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Xinyi Solar Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Xinyi Solar Holdings's EBIT growth rate and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Xinyi Solar Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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