Is Shougang Concord Century Holdings (HKG:103) Using Too Much 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 note that Shougang Concord Century Holdings Limited (HKG:103) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Shougang Concord Century Holdings

What Is Shougang Concord Century Holdings's Net Debt?

As you can see below, Shougang Concord Century Holdings had HK$660.5m of debt at December 2020, down from HK$821.3m a year prior. On the flip side, it has HK$93.3m in cash leading to net debt of about HK$567.3m.

How Healthy Is Shougang Concord Century Holdings' Balance Sheet?

We can see from the most recent balance sheet that Shougang Concord Century Holdings had liabilities of HK$1.71b falling due within a year, and liabilities of HK$20.6m due beyond that. On the other hand, it had cash of HK$93.3m and HK$1.51b worth of receivables due within a year. So its liabilities total HK$122.3m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Shougang Concord Century Holdings is worth HK$522.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Shougang Concord Century Holdings's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.2 times interest expense) certainly does not do anything to dispel this impression. One way Shougang Concord Century Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. 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 Shougang Concord Century Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Shougang Concord Century Holdings's free cash flow amounted to 31% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Shougang Concord Century Holdings's ability to to grow its EBIT and its interest cover gave us comfort that it can handle its debt. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Shougang Concord Century Holdings is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Shougang Concord Century Holdings .

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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