China Merchants Shekou Industrial Zone Holdings (SZSE:001979) Use Of Debt Could Be Considered Risky

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. We note that China Merchants Shekou Industrial Zone Holdings Co., Ltd. (SZSE:001979) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Merchants Shekou Industrial Zone Holdings

What Is China Merchants Shekou Industrial Zone Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 China Merchants Shekou Industrial Zone Holdings had CN¥222.4b of debt, an increase on CN¥207.1b, over one year. On the flip side, it has CN¥86.0b in cash leading to net debt of about CN¥136.5b.

A Look At China Merchants Shekou Industrial Zone Holdings' Liabilities

We can see from the most recent balance sheet that China Merchants Shekou Industrial Zone Holdings had liabilities of CN¥433.3b falling due within a year, and liabilities of CN¥197.2b due beyond that. Offsetting this, it had CN¥86.0b in cash and CN¥118.2b in receivables that were due within 12 months. So its liabilities total CN¥426.4b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥88.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, China Merchants Shekou Industrial Zone Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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).

As it happens China Merchants Shekou Industrial Zone Holdings has a fairly concerning net debt to EBITDA ratio of 12.4 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, China Merchants Shekou Industrial Zone Holdings's EBIT fell a jaw-dropping 49% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Merchants Shekou Industrial Zone Holdings'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, China Merchants Shekou Industrial Zone Holdings's free cash flow amounted to 33% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, China Merchants Shekou Industrial Zone Holdings's EBIT growth rate 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 at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think China Merchants Shekou Industrial Zone Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. We've identified 2 warning signs with China Merchants Shekou Industrial Zone Holdings (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

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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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.