Here's Why Shanghai Industrial Holdings (HKG:363) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Shanghai Industrial Holdings Limited (HKG:363) 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Shanghai Industrial Holdings

What Is Shanghai Industrial Holdings's Debt?

As you can see below, at the end of June 2021, Shanghai Industrial Holdings had HK$63.2b of debt, up from HK$53.8b a year ago. Click the image for more detail. However, it also had HK$32.5b in cash, and so its net debt is HK$30.7b.

How Healthy Is Shanghai Industrial Holdings' Balance Sheet?

We can see from the most recent balance sheet that Shanghai Industrial Holdings had liabilities of HK$66.7b falling due within a year, and liabilities of HK$58.9b due beyond that. Offsetting these obligations, it had cash of HK$32.5b as well as receivables valued at HK$13.1b due within 12 months. So its liabilities total HK$80.0b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$12.7b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Shanghai Industrial Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Shanghai Industrial Holdings's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 6.5 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. Shanghai Industrial Holdings grew its EBIT by 2.9% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shanghai Industrial Holdings's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Shanghai Industrial Holdings's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Shanghai Industrial Holdings's level of total liabilities was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Shanghai Industrial Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Shanghai Industrial Holdings you should be aware of, and 1 of them is significant.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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 (at) simplywallst.com.