Shenzhen Huaqiang Industry (SZSE:000062) Takes On Some Risk With Its Use Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Shenzhen Huaqiang Industry Co., Ltd. (SZSE:000062) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shenzhen Huaqiang Industry

What Is Shenzhen Huaqiang Industry's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shenzhen Huaqiang Industry had CN¥6.51b of debt, an increase on CN¥5.85b, over one year. On the flip side, it has CN¥2.70b in cash leading to net debt of about CN¥3.82b.

How Strong Is Shenzhen Huaqiang Industry's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Huaqiang Industry had liabilities of CN¥7.19b falling due within a year, and liabilities of CN¥1.26b due beyond that. Offsetting these obligations, it had cash of CN¥2.70b as well as receivables valued at CN¥5.26b due within 12 months. So its liabilities total CN¥498.8m more than the combination of its cash and short-term receivables.

Since publicly traded Shenzhen Huaqiang Industry shares are worth a total of CN¥8.92b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shenzhen Huaqiang Industry has a debt to EBITDA ratio of 3.9 and its EBIT covered its interest expense 4.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Shenzhen Huaqiang Industry's EBIT was down 25% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shenzhen Huaqiang Industry will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Shenzhen Huaqiang Industry's free cash flow amounted to 39% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Shenzhen Huaqiang Industry's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its level of total liabilities is relatively strong. When we consider all the factors discussed, it seems to us that Shenzhen Huaqiang Industry 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. Case in point: We've spotted 3 warning signs for Shenzhen Huaqiang Industry you should be aware of, and 1 of them is a bit unpleasant.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com