Does South China Holdings (HKG:413) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, South China Holdings Company Limited (HKG:413) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

Check out our latest analysis for South China Holdings

How Much Debt Does South China Holdings Carry?

The chart below, which you can click on for greater detail, shows that South China Holdings had HK$4.79b in debt in December 2020; about the same as the year before. However, it does have HK$597.2m in cash offsetting this, leading to net debt of about HK$4.19b.

A Look At South China Holdings' Liabilities

We can see from the most recent balance sheet that South China Holdings had liabilities of HK$3.74b falling due within a year, and liabilities of HK$4.43b due beyond that. Offsetting this, it had HK$597.2m in cash and HK$659.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$6.92b.

This deficit casts a shadow over the HK$1.69b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, South China Holdings 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

South China Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (20.6), and fairly weak interest coverage, since EBIT is just 0.80 times the interest expense. The debt burden here is substantial. However, one redeeming factor is that South China Holdings grew its EBIT at 19% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is South China 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 always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, South China Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, South China Holdings's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that South China Holdings'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. 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 instance, we've identified 4 warning signs for South China Holdings (1 can't be ignored) you should be aware of.

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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