We Think Hubei Chutian Smart CommunicationLtd (SHSE:600035) Is Taking Some Risk With Its 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.' 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. We can see that Hubei Chutian Smart Communication Co.,Ltd. (SHSE:600035) does use debt in its business. 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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hubei Chutian Smart CommunicationLtd

How Much Debt Does Hubei Chutian Smart CommunicationLtd Carry?

As you can see below, Hubei Chutian Smart CommunicationLtd had CN¥8.57b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had CN¥792.4m in cash, and so its net debt is CN¥7.78b.

A Look At Hubei Chutian Smart CommunicationLtd's Liabilities

The latest balance sheet data shows that Hubei Chutian Smart CommunicationLtd had liabilities of CN¥5.15b due within a year, and liabilities of CN¥4.66b falling due after that. On the other hand, it had cash of CN¥792.4m and CN¥356.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.66b.

When you consider that this deficiency exceeds the company's CN¥7.52b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hubei Chutian Smart CommunicationLtd has net debt to EBITDA of 3.7 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.6 suggests it can easily service that debt. Sadly, Hubei Chutian Smart CommunicationLtd's EBIT actually dropped 9.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hubei Chutian Smart CommunicationLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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, Hubei Chutian Smart CommunicationLtd generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Neither Hubei Chutian Smart CommunicationLtd's ability to handle its total liabilities nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. It's also worth noting that Hubei Chutian Smart CommunicationLtd is in the Infrastructure industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Hubei Chutian Smart CommunicationLtd's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Hubei Chutian Smart CommunicationLtd .

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.