These 4 Measures Indicate That Sino-Ocean Group Holding (HKG:3377) Is Using Debt In A Risky Way

By
Simply Wall St
Published
September 16, 2021
SEHK:3377
Source: Shutterstock

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.' 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 Sino-Ocean Group Holding Limited (HKG:3377) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sino-Ocean Group Holding

What Is Sino-Ocean Group Holding's Net Debt?

The chart below, which you can click on for greater detail, shows that Sino-Ocean Group Holding had CN¥85.7b in debt in June 2021; about the same as the year before. However, it also had CN¥32.8b in cash, and so its net debt is CN¥52.9b.

debt-equity-history-analysis
SEHK:3377 Debt to Equity History September 16th 2021

How Strong Is Sino-Ocean Group Holding's Balance Sheet?

We can see from the most recent balance sheet that Sino-Ocean Group Holding had liabilities of CN¥126.2b falling due within a year, and liabilities of CN¥69.3b due beyond that. On the other hand, it had cash of CN¥32.8b and CN¥61.9b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥100.8b.

The deficiency here weighs heavily on the CN¥9.16b 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. After all, Sino-Ocean Group Holding would likely require a major re-capitalisation if it had to pay its creditors today.

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.

As it happens Sino-Ocean Group Holding has a fairly concerning net debt to EBITDA ratio of 7.4 but very strong interest coverage of 48.9. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Sino-Ocean Group Holding's EBIT fell a jaw-dropping 21% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Sino-Ocean Group Holding 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Sino-Ocean Group Holding reported free cash flow worth 7.4% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Sino-Ocean Group Holding's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Sino-Ocean Group Holding has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. 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 Sino-Ocean Group Holding (including 1 which is significant) .

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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