The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Yuexiu Transport Infrastructure Limited (HKG:1052) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Yuexiu Transport Infrastructure Carry?
The image below, which you can click on for greater detail, shows that Yuexiu Transport Infrastructure had debt of CN¥6.82b at the end of June 2019, a reduction from CN¥8.70b over a year. On the flip side, it has CN¥2.19b in cash leading to net debt of about CN¥4.63b.
A Look At Yuexiu Transport Infrastructure’s Liabilities
The latest balance sheet data shows that Yuexiu Transport Infrastructure had liabilities of CN¥749.3m due within a year, and liabilities of CN¥8.69b falling due after that. Offsetting this, it had CN¥2.19b in cash and CN¥212.1m in receivables that were due within 12 months. So its liabilities total CN¥7.05b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of CN¥10.4b, so it does suggest shareholders should keep an eye on Yuexiu Transport Infrastructure’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
Yuexiu Transport Infrastructure has net debt worth 1.9 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 6.4 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Unfortunately, Yuexiu Transport Infrastructure saw its EBIT slide 3.6% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Yuexiu Transport Infrastructure 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 the logical step is to look at the proportion of that EBIT that is matched by actual 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 our analysis Yuexiu Transport Infrastructure’s conversion of EBIT to free cash flow should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. It’s also worth noting that Yuexiu Transport Infrastructure is in the Infrastructure industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Yuexiu Transport Infrastructure is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Yuexiu Transport Infrastructure’s dividend history, without delay!
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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