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.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. Importantly, Shangri-La Asia Limited (HKG:69) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Shangri-La Asia’s Net Debt?
As you can see below, Shangri-La Asia had US$5.18b of debt, at December 2018, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$1.08b, its net debt is less, at about US$4.10b.
A Look At Shangri-La Asia’s Liabilities
According to the last reported balance sheet, Shangri-La Asia had liabilities of US$1.45b due within 12 months, and liabilities of US$5.04b due beyond 12 months. On the other hand, it had cash of US$1.08b and US$258.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.15b.
Given this deficit is actually higher than the company’s market capitalization of US$3.76b, we think shareholders really should watch Shangri-La Asia’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 2.1 times and a disturbingly high net debt to EBITDA ratio of 6.3 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. Looking on the bright side, Shangri-La Asia boosted its EBIT by a silky 57% in the last year. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. 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.
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. Looking at the most recent three years, Shangri-La Asia recorded free cash flow of 43% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
To be frank both Shangri-La Asia’s level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, we think it’s fair to say that Shangri-La Asia has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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