We Think Shenglong Splendecor International (HKG:8481) 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. As with many other companies Shenglong Splendecor International Limited (HKG:8481) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Shenglong Splendecor International

What Is Shenglong Splendecor International's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shenglong Splendecor International had CN¥138.0m of debt in June 2020, down from CN¥154.5m, one year before. However, it does have CN¥24.6m in cash offsetting this, leading to net debt of about CN¥113.4m.

A Look At Shenglong Splendecor International's Liabilities

We can see from the most recent balance sheet that Shenglong Splendecor International had liabilities of CN¥254.3m falling due within a year, and liabilities of CN¥4.30m due beyond that. On the other hand, it had cash of CN¥24.6m and CN¥78.0m worth of receivables due within a year. So its liabilities total CN¥156.0m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CN¥123.1m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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 3.0, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 13.0 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. One way Shenglong Splendecor International could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. 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 we always check how much of that EBIT is translated into 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.

Our View

We'd go so far as to say Shenglong Splendecor International's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Shenglong Splendecor International'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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Shenglong Splendecor International 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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