Here's Why Shunten International (Holdings) (HKG:932) Can Manage Its Debt Responsibly

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 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. We note that Shunten International (Holdings) Limited (HKG:932) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

View our latest analysis for Shunten International (Holdings)

How Much Debt Does Shunten International (Holdings) Carry?

The image below, which you can click on for greater detail, shows that Shunten International (Holdings) had debt of HK$156.1m at the end of September 2020, a reduction from HK$318.5m over a year. On the flip side, it has HK$27.0m in cash leading to net debt of about HK$129.1m.

A Look At Shunten International (Holdings)'s Liabilities

According to the last reported balance sheet, Shunten International (Holdings) had liabilities of HK$140.3m due within 12 months, and liabilities of HK$66.5m due beyond 12 months. Offsetting this, it had HK$27.0m in cash and HK$91.5m in receivables that were due within 12 months. So it has liabilities totalling HK$88.4m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Shunten International (Holdings) is worth HK$384.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). 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).

While Shunten International (Holdings)'s debt to EBITDA ratio (5.0) suggests that it uses some debt, its interest cover is very weak, at 0.40, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Shunten International (Holdings) is that it turned last year's EBIT loss into a gain of HK$13m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shunten International (Holdings) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Shunten International (Holdings) produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Shunten International (Holdings)'s interest cover was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Shunten International (Holdings)'s use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Shunten International (Holdings) you should be aware of, and 1 of them is significant.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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