We Think Shenzhen Energy Group (SZSE:000027) Is Taking Some Risk With Its Debt

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 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 Shenzhen Energy Group Co., Ltd. (SZSE:000027) does use debt in its business. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Shenzhen Energy Group

What Is Shenzhen Energy Group's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Shenzhen Energy Group had debt of CN¥84.0b, up from CN¥66.4b in one year. On the flip side, it has CN¥21.8b in cash leading to net debt of about CN¥62.2b.

A Look At Shenzhen Energy Group's Liabilities

The latest balance sheet data shows that Shenzhen Energy Group had liabilities of CN¥35.8b due within a year, and liabilities of CN¥69.0b falling due after that. Offsetting these obligations, it had cash of CN¥21.8b as well as receivables valued at CN¥15.4b due within 12 months. So its liabilities total CN¥67.7b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥35.6b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Shenzhen Energy Group would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Shenzhen Energy Group has a rather high debt to EBITDA ratio of 5.5 which suggests a meaningful debt load. However, its interest coverage of 4.8 is reasonably strong, which is a good sign. Importantly, Shenzhen Energy Group grew its EBIT by 41% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shenzhen Energy Group's earnings that will influence how the balance sheet holds up in the future. 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, 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. During the last three years, Shenzhen Energy Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Shenzhen Energy Group's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Shenzhen Energy Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example Shenzhen Energy Group has 4 warning signs (and 2 which are concerning) we think you should know about.

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.