Is Shanghai Industrial Holdings (HKG:363) Using Too Much Debt?

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 note that Shanghai Industrial Holdings Limited (HKG:363) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Shanghai Industrial Holdings

What Is Shanghai Industrial Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Shanghai Industrial Holdings had HK$56.9b of debt, an increase on HK$54.7b, over one year. However, because it has a cash reserve of HK$29.1b, its net debt is less, at about HK$27.8b.

How Healthy Is Shanghai Industrial Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shanghai Industrial Holdings had liabilities of HK$60.7b due within 12 months and liabilities of HK$52.1b due beyond that. Offsetting these obligations, it had cash of HK$29.1b as well as receivables valued at HK$14.0b due within 12 months. So it has liabilities totalling HK$69.7b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$12.4b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Shanghai Industrial Holdings 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shanghai Industrial Holdings has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 5.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, Shanghai Industrial Holdings's EBIT fell a jaw-dropping 28% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shanghai Industrial Holdings reported free cash flow worth 12% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Shanghai Industrial Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. After considering the datapoints discussed, we think Shanghai Industrial Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 Shanghai Industrial Holdings has 2 warning signs (and 1 which is significant) we think you should know about.

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. 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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