We Think Xinji Shaxi Group (HKG:3603) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Xinji Shaxi Group Co., Ltd (HKG:3603) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Xinji Shaxi Group

How Much Debt Does Xinji Shaxi Group Carry?

The image below, which you can click on for greater detail, shows that Xinji Shaxi Group had debt of CN¥859.9m at the end of June 2024, a reduction from CN¥918.1m over a year. On the flip side, it has CN¥554.5m in cash leading to net debt of about CN¥305.4m.

How Healthy Is Xinji Shaxi Group's Balance Sheet?

We can see from the most recent balance sheet that Xinji Shaxi Group had liabilities of CN¥397.3m falling due within a year, and liabilities of CN¥1.14b due beyond that. Offsetting this, it had CN¥554.5m in cash and CN¥70.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥913.5m.

The deficiency here weighs heavily on the CN¥70.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Xinji Shaxi Group 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Xinji Shaxi Group has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.3 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. One way Xinji Shaxi Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xinji Shaxi Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Xinji Shaxi Group recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Xinji Shaxi Group's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its conversion of EBIT to free cash flow was refreshing. When we consider all the factors discussed, it seems to us that Xinji Shaxi Group 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Xinji Shaxi Group (2 don't sit too well with us) you should be aware of.

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. 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.