These 4 Measures Indicate That China Shanshui Cement Group (HKG:691) Is Using Debt Extensively

Warren Buffett famously said, '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 can see that China Shanshui Cement Group Limited (HKG:691) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out the opportunities and risks within the HK Basic Materials industry.

What Is China Shanshui Cement Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 China Shanshui Cement Group had CN¥3.89b of debt, an increase on CN¥3.05b, over one year. However, it also had CN¥1.84b in cash, and so its net debt is CN¥2.05b.

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

We can see from the most recent balance sheet that China Shanshui Cement Group had liabilities of CN¥10.2b falling due within a year, and liabilities of CN¥1.61b due beyond that. Offsetting this, it had CN¥1.84b in cash and CN¥3.11b in receivables that were due within 12 months. So it has liabilities totalling CN¥6.82b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥6.45b, we think shareholders really should watch China Shanshui Cement Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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).

China Shanshui Cement Group has a low net debt to EBITDA ratio of only 0.37. And its EBIT covers its interest expense a whopping 44.8 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, China Shanshui Cement Group's EBIT dived 16%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Shanshui Cement Group's earnings that will influence how the balance sheet holds up in the future. 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, China Shanshui Cement Group recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, China Shanshui Cement Group's level of total liabilities left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Shanshui Cement Group stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. 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.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.