We Think China Shuifa Singyes Energy Holdings (HKG:750) Is Taking Some Risk With Its Debt

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.' 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, China Shuifa Singyes Energy Holdings Limited (HKG:750) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Shuifa Singyes Energy Holdings

How Much Debt Does China Shuifa Singyes Energy Holdings Carry?

The image below, which you can click on for greater detail, shows that China Shuifa Singyes Energy Holdings had debt of CN¥5.22b at the end of June 2021, a reduction from CN¥5.49b over a year. However, because it has a cash reserve of CN¥567.3m, its net debt is less, at about CN¥4.65b.

How Strong Is China Shuifa Singyes Energy Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Shuifa Singyes Energy Holdings had liabilities of CN¥5.72b due within 12 months and liabilities of CN¥2.95b due beyond that. Offsetting these obligations, it had cash of CN¥567.3m as well as receivables valued at CN¥7.23b due within 12 months. So it has liabilities totalling CN¥875.8m more than its cash and near-term receivables, combined.

This deficit isn't so bad because China Shuifa Singyes Energy Holdings is worth CN¥3.64b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.58 times and a disturbingly high net debt to EBITDA ratio of 11.9 hit our confidence in China Shuifa Singyes Energy Holdings like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that China Shuifa Singyes Energy Holdings achieved a positive EBIT of CN¥178m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Shuifa Singyes Energy Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, China Shuifa Singyes Energy Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, China Shuifa Singyes Energy Holdings's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. Looking at the bigger picture, it seems clear to us that China Shuifa Singyes Energy 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for China Shuifa Singyes Energy Holdings (2 don't sit too well with us!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.
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