These 4 Measures Indicate That Shenglong Splendecor International (HKG:8481) Is Using Debt Extensively

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.' 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. We can see that Shenglong Splendecor International Limited (HKG:8481) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Shenglong Splendecor International

What Is Shenglong Splendecor International's Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Shenglong Splendecor International had debt of CN¥162.5m, up from CN¥138.0m in one year. However, because it has a cash reserve of CN¥9.32m, its net debt is less, at about CN¥153.2m.

How Strong Is Shenglong Splendecor International's Balance Sheet?

The latest balance sheet data shows that Shenglong Splendecor International had liabilities of CN¥267.3m due within a year, and liabilities of CN¥65.8m falling due after that. On the other hand, it had cash of CN¥9.32m and CN¥116.5m worth of receivables due within a year. So it has liabilities totalling CN¥207.3m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥77.3m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Shenglong Splendecor International 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Shenglong Splendecor International has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 3.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Shenglong Splendecor International improved its EBIT by 7.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But it is Shenglong Splendecor International's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Shenglong Splendecor International 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

To be frank both Shenglong Splendecor International's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Shenglong Splendecor International has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. We've identified 2 warning signs with Shenglong Splendecor International (at least 1 which is concerning) , and understanding them should be part of your investment process.

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. 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.