Is Shanghai Industrial Holdings (HKG:363) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Shanghai Industrial Holdings Limited (HKG:363) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Shanghai Industrial Holdings

What Is Shanghai Industrial Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Shanghai Industrial Holdings had HK$66.7b of debt, an increase on HK$63.2b, over one year. On the flip side, it has HK$34.4b in cash leading to net debt of about HK$32.2b.

How Strong Is Shanghai Industrial Holdings' Balance Sheet?

The latest balance sheet data shows that Shanghai Industrial Holdings had liabilities of HK$60.8b due within a year, and liabilities of HK$56.1b falling due after that. Offsetting this, it had HK$34.4b in cash and HK$11.0b in receivables that were due within 12 months. So its liabilities total HK$71.4b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$9.42b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Shanghai Industrial Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Shanghai Industrial Holdings has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 6.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Shanghai Industrial Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 10%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shanghai Industrial Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Shanghai Industrial Holdings recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mulling over Shanghai Industrial Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Shanghai Industrial Holdings has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For instance, we've identified 4 warning signs for Shanghai Industrial Holdings (2 are potentially serious) you should be aware of.

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.

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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.