We Think Guangdong Guanhao High-Tech (SHSE:600433) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Guangdong Guanhao High-Tech Co., Ltd. (SHSE:600433) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Guangdong Guanhao High-Tech

What Is Guangdong Guanhao High-Tech's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Guangdong Guanhao High-Tech had CN¥2.71b of debt, an increase on CN¥2.21b, over one year. However, because it has a cash reserve of CN¥720.9m, its net debt is less, at about CN¥1.98b.

How Strong Is Guangdong Guanhao High-Tech's Balance Sheet?

According to the last reported balance sheet, Guangdong Guanhao High-Tech had liabilities of CN¥3.48b due within 12 months, and liabilities of CN¥1.55b due beyond 12 months. On the other hand, it had cash of CN¥720.9m and CN¥1.48b worth of receivables due within a year. So its liabilities total CN¥2.83b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Guangdong Guanhao High-Tech is worth CN¥5.55b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 6.6 hit our confidence in Guangdong Guanhao High-Tech like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Guangdong Guanhao High-Tech is that it turned last year's EBIT loss into a gain of CN¥23m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guangdong Guanhao High-Tech 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Guangdong Guanhao High-Tech 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.

Our View

To be frank both Guangdong Guanhao High-Tech's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Guangdong Guanhao High-Tech to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Guangdong Guanhao High-Tech you should know about.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.