Shunten International (Holdings) (HKG:932) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Shunten International (Holdings) Limited (HKG:932) does use debt in its business. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See 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 at March 2023 Shunten International (Holdings) had debt of HK$159.6m, up from HK$119.0m in one year. However, because it has a cash reserve of HK$13.1m, its net debt is less, at about HK$146.5m.

How Healthy Is Shunten International (Holdings)'s Balance Sheet?

The latest balance sheet data shows that Shunten International (Holdings) had liabilities of HK$192.0m due within a year, and liabilities of HK$4.08m falling due after that. Offsetting these obligations, it had cash of HK$13.1m as well as receivables valued at HK$1.38m due within 12 months. So its liabilities total HK$181.6m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$217.6m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Shunten International (Holdings)'s debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 7.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Shunten International (Holdings)'s EBIT launched higher than Elon Musk, gaining a whopping 7,741% on last year. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent two years, Shunten International (Holdings) recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Shunten International (Holdings)'s ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Shunten International (Holdings)'s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example, we've discovered 3 warning signs for Shunten International (Holdings) (1 doesn't sit too well with us!) that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.