Is Shoucheng Holdings (HKG:697) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Shoucheng Holdings Limited (HKG:697) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Shoucheng Holdings

What Is Shoucheng Holdings's Debt?

As you can see below, at the end of June 2021, Shoucheng Holdings had HK$479.3m of debt, up from HK$445.7m a year ago. Click the image for more detail. But on the other hand it also has HK$4.34b in cash, leading to a HK$3.86b net cash position.

How Strong Is Shoucheng Holdings' Balance Sheet?

According to the last reported balance sheet, Shoucheng Holdings had liabilities of HK$1.21b due within 12 months, and liabilities of HK$1.55b due beyond 12 months. On the other hand, it had cash of HK$4.34b and HK$422.8m worth of receivables due within a year. So it can boast HK$2.00b more liquid assets than total liabilities.

It's good to see that Shoucheng Holdings has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Shoucheng Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Although Shoucheng Holdings made a loss at the EBIT level, last year, it was also good to see that it generated HK$205m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shoucheng Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Shoucheng Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent year, Shoucheng Holdings recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case Shoucheng Holdings has HK$3.86b in net cash and a decent-looking balance sheet. So we are not troubled with Shoucheng Holdings's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Shoucheng Holdings you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.

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