Is Shun Tak Holdings (HKG:242) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Shun Tak Holdings Limited (HKG:242) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Shun Tak Holdings

What Is Shun Tak Holdings's Net Debt?

The chart below, which you can click on for greater detail, shows that Shun Tak Holdings had HK$16.3b in debt in June 2024; about the same as the year before. However, it also had HK$7.76b in cash, and so its net debt is HK$8.57b.

How Strong Is Shun Tak Holdings' Balance Sheet?

According to the last reported balance sheet, Shun Tak Holdings had liabilities of HK$9.16b due within 12 months, and liabilities of HK$9.44b due beyond 12 months. On the other hand, it had cash of HK$7.76b and HK$2.57b worth of receivables due within a year. So it has liabilities totalling HK$8.27b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$1.87b 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, Shun Tak Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 7.3 hit our confidence in Shun Tak Holdings like a one-two punch to the gut. The debt burden here is substantial. The good news is that Shun Tak Holdings grew its EBIT a smooth 58% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shun Tak Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Shun Tak Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We feel some trepidation about Shun Tak Holdings's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Shun Tak Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Shun Tak Holdings is showing 1 warning sign in our investment analysis , you should know about...

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.