Shenma IndustryLtd (SHSE:600810) Takes On Some Risk With Its Use Of Debt

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. Importantly, Shenma Industry Co.Ltd (SHSE:600810) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Shenma IndustryLtd

How Much Debt Does Shenma IndustryLtd Carry?

As you can see below, Shenma IndustryLtd had CN¥14.8b of debt at September 2024, down from CN¥17.3b a year prior. On the flip side, it has CN¥7.43b in cash leading to net debt of about CN¥7.34b.

A Look At Shenma IndustryLtd's Liabilities

We can see from the most recent balance sheet that Shenma IndustryLtd had liabilities of CN¥5.78b falling due within a year, and liabilities of CN¥12.2b due beyond that. Offsetting this, it had CN¥7.43b in cash and CN¥2.98b in receivables that were due within 12 months. So it has liabilities totalling CN¥7.58b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥8.31b, so it does suggest shareholders should keep an eye on Shenma IndustryLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shenma IndustryLtd shareholders face the double whammy of a high net debt to EBITDA ratio (6.8), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. This means we'd consider it to have a heavy debt load. The good news is that Shenma IndustryLtd grew its EBIT a smooth 42% over the last twelve months. 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shenma IndustryLtd's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shenma IndustryLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Shenma IndustryLtd's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Shenma IndustryLtd's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 2 warning signs for Shenma IndustryLtd you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.