Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Yuexiu Transport Infrastructure Limited (HKG:1052) makes use of debt. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Yuexiu Transport Infrastructure’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 Yuexiu Transport Infrastructure had CN¥18.3b of debt, an increase on CN¥7.61b, over one year. However, because it has a cash reserve of CN¥1.44b, its net debt is less, at about CN¥16.9b.
How Healthy Is Yuexiu Transport Infrastructure’s Balance Sheet?
We can see from the most recent balance sheet that Yuexiu Transport Infrastructure had liabilities of CN¥2.54b falling due within a year, and liabilities of CN¥20.6b due beyond that. Offsetting this, it had CN¥1.44b in cash and CN¥363.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥21.4b.
The deficiency here weighs heavily on the CN¥7.51b 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. After all, Yuexiu Transport Infrastructure 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Yuexiu Transport Infrastructure has a rather high debt to EBITDA ratio of 7.0 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.0 times, suggesting it can responsibly service its obligations. Unfortunately, Yuexiu Transport Infrastructure saw its EBIT slide 2.7% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Yuexiu Transport Infrastructure 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Yuexiu Transport Infrastructure actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
On the face of it, Yuexiu Transport Infrastructure’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 on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We should also note that Infrastructure industry companies like Yuexiu Transport Infrastructure commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Yuexiu Transport Infrastructure’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 3 warning signs for Yuexiu Transport Infrastructure you should be aware of, and 1 of them shouldn’t be ignored.
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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