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, Shenglong Splendecor International Limited (HKG:8481) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Shenglong Splendecor International Carry?
The image below, which you can click on for greater detail, shows that at December 2018 Shenglong Splendecor International had debt of CN¥110.8m, up from CN¥102.1m in one year. However, it does have CN¥16.9m in cash offsetting this, leading to net debt of about CN¥93.9m.
How Healthy Is Shenglong Splendecor International’s Balance Sheet?
According to the last reported balance sheet, Shenglong Splendecor International had liabilities of CN¥247.9m due within 12 months, and liabilities of CN¥3.42m due beyond 12 months. On the other hand, it had cash of CN¥16.9m and CN¥86.1m worth of receivables due within a year. So it has liabilities totalling CN¥148.3m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CN¥152.0m, so it does suggest shareholders should keep an eye on Shenglong Splendecor International’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Because it carries more debt than cash, we think it’s worth watching Shenglong Splendecor International’s balance sheet over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt to EBITDA of 3.02 Shenglong Splendecor International has a fairly reasonable amount of debt. On the plus side, its EBIT was 7.74 times its interest expense, and its net debt to EBITDA, was quite high, at 3.02. One way Shenglong Splendecor International could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 18%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shenglong Splendecor International’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Shenglong Splendecor International burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Shenglong Splendecor International’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Shenglong Splendecor International’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Shenglong Splendecor International insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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