We Think Sheung Moon Holdings (HKG:8523) Is Taking Some Risk With Its Debt

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Sheung Moon Holdings Limited (HKG:8523) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Sheung Moon Holdings

How Much Debt Does Sheung Moon Holdings Carry?

As you can see below, at the end of September 2020, Sheung Moon Holdings had HK$97.1m of debt, up from HK$44.2m a year ago. Click the image for more detail. On the flip side, it has HK$15.3m in cash leading to net debt of about HK$81.8m.

How Healthy Is Sheung Moon Holdings' Balance Sheet?

The latest balance sheet data shows that Sheung Moon Holdings had liabilities of HK$192.2m due within a year, and liabilities of HK$17.9m falling due after that. Offsetting this, it had HK$15.3m in cash and HK$252.8m in receivables that were due within 12 months. So it actually has HK$58.1m more liquid assets than total liabilities.

This surplus suggests that Sheung Moon Holdings is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 2.1, Sheung Moon Holdings uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. Importantly, Sheung Moon Holdings's EBIT fell a jaw-dropping 23% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Sheung Moon Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Sheung Moon 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

Both Sheung Moon Holdings's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But its not so bad at staying on top of its total liabilities. When we consider all the factors discussed, it seems to us that Sheung Moon Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Sheung Moon Holdings (2 are a bit unpleasant!) 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. 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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