China Shanshui Cement Group (HKG:691) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that China Shanshui Cement Group Limited (HKG:691) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Shanshui Cement Group

What Is China Shanshui Cement Group's Net Debt?

As you can see below, China Shanshui Cement Group had CN¥2.53b of debt at December 2021, down from CN¥4.82b a year prior. However, it does have CN¥1.42b in cash offsetting this, leading to net debt of about CN¥1.11b.

How Strong Is China Shanshui Cement Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Shanshui Cement Group had liabilities of CN¥9.34b due within 12 months and liabilities of CN¥866.7m due beyond that. Offsetting this, it had CN¥1.42b in cash and CN¥3.57b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.21b.

This is a mountain of leverage relative to its market capitalization of CN¥8.47b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Shanshui Cement Group has a low net debt to EBITDA ratio of only 0.17. And its EBIT easily covers its interest expense, being 33.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that China Shanshui Cement Group saw its EBIT decline by 6.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Shanshui Cement Group 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, China Shanshui Cement Group's free cash flow amounted to 42% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

China Shanshui Cement Group's interest cover was a real positive on this analysis, as was its net debt to EBITDA. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about China Shanshui Cement Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for China Shanshui Cement Group you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.