Is SDIC Power Holdings (SHSE:600886) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies SDIC Power Holdings Co., Ltd (SHSE:600886) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for SDIC Power Holdings

What Is SDIC Power Holdings's Debt?

As you can see below, at the end of March 2024, SDIC Power Holdings had CN¥148.1b of debt, up from CN¥140.4b a year ago. Click the image for more detail. However, it does have CN¥12.4b in cash offsetting this, leading to net debt of about CN¥135.7b.

How Strong Is SDIC Power Holdings' Balance Sheet?

The latest balance sheet data shows that SDIC Power Holdings had liabilities of CN¥43.0b due within a year, and liabilities of CN¥132.8b falling due after that. Offsetting these obligations, it had cash of CN¥12.4b as well as receivables valued at CN¥15.5b due within 12 months. So it has liabilities totalling CN¥147.9b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's massive market capitalization of CN¥133.4b, we think shareholders really should watch SDIC Power Holdings's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

SDIC Power Holdings's debt is 4.8 times its EBITDA, and its EBIT cover its interest expense 5.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We note that SDIC Power Holdings grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if SDIC Power Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, SDIC Power Holdings's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither SDIC Power Holdings's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think SDIC Power Holdings's debt poses some risks to the business. 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. Be aware that SDIC Power Holdings is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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