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

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. We note that Shun Tak Holdings Limited (HKG:242) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Shun Tak Holdings

What Is Shun Tak Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Shun Tak Holdings had HK$18.4b in debt in June 2022; about the same as the year before. However, it does have HK$7.96b in cash offsetting this, leading to net debt of about HK$10.4b.

A Look At Shun Tak Holdings' Liabilities

We can see from the most recent balance sheet that Shun Tak Holdings had liabilities of HK$4.49b falling due within a year, and liabilities of HK$16.4b due beyond that. On the other hand, it had cash of HK$7.96b and HK$1.08b worth of receivables due within a year. So it has liabilities totalling HK$11.9b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$5.20b 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, Shun Tak Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

Shun Tak Holdings has a rather high debt to EBITDA ratio of 7.1 which suggests a meaningful debt load. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Importantly Shun Tak Holdings's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shun Tak Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Shun Tak Holdings generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both Shun Tak Holdings's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Shun Tak Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 2 warning signs we've spotted with Shun Tak Holdings (including 1 which doesn't sit too well with us) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.