We Think XianheLtd (SHSE:603733) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Xianhe Co.,Ltd. (SHSE:603733) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for XianheLtd

How Much Debt Does XianheLtd Carry?

As you can see below, at the end of June 2024, XianheLtd had CN¥9.76b of debt, up from CN¥5.54b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥1.44b, its net debt is less, at about CN¥8.32b.

How Strong Is XianheLtd's Balance Sheet?

The latest balance sheet data shows that XianheLtd had liabilities of CN¥4.91b due within a year, and liabilities of CN¥8.20b falling due after that. Offsetting these obligations, it had cash of CN¥1.44b as well as receivables valued at CN¥1.97b due within 12 months. So it has liabilities totalling CN¥9.70b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥11.1b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Strangely XianheLtd has a sky high EBITDA ratio of 5.7, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, XianheLtd's EBIT launched higher than Elon Musk, gaining a whopping 132% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if XianheLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, XianheLtd 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

While XianheLtd's conversion of EBIT to free cash flow has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that XianheLtd is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 3 warning signs with XianheLtd (at least 2 which make us uncomfortable) , and understanding them should be part of your investment process.

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.