Xiwang Special Steel (HKG:1266) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Xiwang Special Steel Company Limited (HKG:1266) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Xiwang Special Steel

What Is Xiwang Special Steel's Net Debt?

As you can see below, Xiwang Special Steel had CN¥3.65b of debt at June 2021, down from CN¥4.16b a year prior. On the flip side, it has CN¥444.4m in cash leading to net debt of about CN¥3.20b.

How Strong Is Xiwang Special Steel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Xiwang Special Steel had liabilities of CN¥9.52b due within 12 months and liabilities of CN¥651.7m due beyond that. Offsetting this, it had CN¥444.4m in cash and CN¥108.2m in receivables that were due within 12 months. So its liabilities total CN¥9.62b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥1.35b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Xiwang Special Steel would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Xiwang Special Steel's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One redeeming factor for Xiwang Special Steel is that it turned last year's EBIT loss into a gain of CN¥734m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xiwang Special Steel 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. Over the last year, Xiwang Special Steel reported free cash flow worth 14% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Xiwang Special Steel's level of total liabilities was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Xiwang Special Steel's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Case in point: We've spotted 3 warning signs for Xiwang Special Steel you should be aware of, and 1 of them makes us a bit uncomfortable.

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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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.
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