These 4 Measures Indicate That Shanghai Industrial Holdings (HKG:363) Is Using Debt Extensively

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Shanghai Industrial Holdings Limited (HKG:363) does carry debt. But is this debt a concern to shareholders?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Net Debt?

As you can see below, Shanghai Industrial Holdings had HK$53.8b of debt at June 2020, down from HK$57.4b a year prior. However, because it has a cash reserve of HK$25.1b, its net debt is less, at about HK$28.6b.

A Look At Shanghai Industrial Holdings's Liabilities

We can see from the most recent balance sheet that Shanghai Industrial Holdings had liabilities of HK$51.2b falling due within a year, and liabilities of HK$46.3b due beyond that. On the other hand, it had cash of HK$25.1b and HK$11.1b worth of receivables due within a year. So its liabilities total HK$61.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$11.5b 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.

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 3.1 and its EBIT covered its interest expense 5.8 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Shanghai Industrial Holdings saw its EBIT slide 6.0% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shanghai Industrial Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shanghai Industrial Holdings reported free cash flow worth 5.8% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

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 its interest cover is not so bad. We're quite clear that we consider Shanghai Industrial Holdings to be really rather risky, as a result of its balance sheet health. 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. 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. For instance, we've identified 3 warning signs for Shanghai Industrial Holdings (1 is significant) you should be aware of.

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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