Is Hong Kong Shanghai Alliance Holdings (HKG:1001) A Risky Investment?

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, Hong Kong Shanghai Alliance Holdings Limited (HKG:1001) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

See our latest analysis for Hong Kong Shanghai Alliance Holdings

What Is Hong Kong Shanghai Alliance Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Hong Kong Shanghai Alliance Holdings had HK$1.46b in debt in March 2021; about the same as the year before. On the flip side, it has HK$119.1m in cash leading to net debt of about HK$1.34b.

How Healthy Is Hong Kong Shanghai Alliance Holdings' Balance Sheet?

We can see from the most recent balance sheet that Hong Kong Shanghai Alliance Holdings had liabilities of HK$1.07b falling due within a year, and liabilities of HK$887.0m due beyond that. Offsetting these obligations, it had cash of HK$119.1m as well as receivables valued at HK$363.8m due within 12 months. So its liabilities total HK$1.47b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$166.7m 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, Hong Kong Shanghai Alliance Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Hong Kong Shanghai Alliance Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (12.8), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Hong Kong Shanghai Alliance Holdings actually grew its EBIT by a hefty 411%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. But it is Hong Kong Shanghai Alliance Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Hong Kong Shanghai Alliance Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We feel some trepidation about Hong Kong Shanghai Alliance Holdings's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Hong Kong Shanghai Alliance Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Hong Kong Shanghai Alliance Holdings you should be aware of, and 2 of them can't be ignored.

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. 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.
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