These 4 Measures Indicate That Xinji Shaxi Group (HKG:3603) Is Using Debt Extensively

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. Importantly, Xinji Shaxi Group Co., Ltd (HKG:3603) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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.

View our latest analysis for Xinji Shaxi Group

What Is Xinji Shaxi Group's Net Debt?

The chart below, which you can click on for greater detail, shows that Xinji Shaxi Group had CN¥630.4m in debt in December 2020; about the same as the year before. However, it also had CN¥182.5m in cash, and so its net debt is CN¥447.9m.

How Strong Is Xinji Shaxi Group's Balance Sheet?

According to the last reported balance sheet, Xinji Shaxi Group had liabilities of CN¥360.1m due within 12 months, and liabilities of CN¥1.03b due beyond 12 months. On the other hand, it had cash of CN¥182.5m and CN¥100.6m worth of receivables due within a year. So its liabilities total CN¥1.11b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Xinji Shaxi Group is worth CN¥2.02b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Xinji Shaxi Group's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 3.9 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Unfortunately, Xinji Shaxi Group saw its EBIT slide 6.0% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Xinji Shaxi Group produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Xinji Shaxi Group's EBIT growth rate and its interest cover were discouraging. But its not so bad at converting EBIT to free cash flow. Taking the abovementioned factors together we do think Xinji Shaxi Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 3 warning signs with Xinji Shaxi Group (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

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. 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.
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