We Think Shenzhen Investment (HKG:604) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Shenzhen Investment Limited (HKG:604) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shenzhen Investment

What Is Shenzhen Investment's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Shenzhen Investment had HK$31.9b of debt, an increase on HK$29.2b, over one year. However, because it has a cash reserve of HK$18.1b, its net debt is less, at about HK$13.8b.

How Strong Is Shenzhen Investment's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Investment had liabilities of HK$58.7b falling due within a year, and liabilities of HK$27.3b due beyond that. On the other hand, it had cash of HK$18.1b and HK$708.6m worth of receivables due within a year. So it has liabilities totalling HK$67.2b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$22.9b 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, Shenzhen Investment would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Shenzhen Investment has a debt to EBITDA ratio of 2.9, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, Shenzhen Investment grew its EBIT by 82% over the last twelve months, and that growth will make it easier to handle its 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 Shenzhen Investment 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.

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. Looking at the most recent three years, Shenzhen Investment recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Shenzhen Investment's level of total liabilities has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Shenzhen Investment is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for Shenzhen Investment (of which 1 doesn't sit too well with us!) 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. 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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