Is China Railway Signal & Communication (HKG:3969) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that China Railway Signal & Communication Corporation Limited (HKG:3969) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

View our latest analysis for China Railway Signal & Communication

What Is China Railway Signal & Communication's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 China Railway Signal & Communication had debt of CN¥2.84b, up from CN¥2.33b in one year. But on the other hand it also has CN¥19.8b in cash, leading to a CN¥16.9b net cash position.

How Healthy Is China Railway Signal & Communication's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Railway Signal & Communication had liabilities of CN¥52.5b due within 12 months and liabilities of CN¥3.32b due beyond that. On the other hand, it had cash of CN¥19.8b and CN¥56.3b worth of receivables due within a year. So it can boast CN¥20.2b more liquid assets than total liabilities.

This surplus strongly suggests that China Railway Signal & Communication has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that China Railway Signal & Communication has more cash than debt is arguably a good indication that it can manage its debt safely.

Also good is that China Railway Signal & Communication grew its EBIT at 13% over the last year, further increasing its ability to manage debt. 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 China Railway Signal & Communication's ability to maintain a healthy balance sheet going forward. 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. While China Railway Signal & Communication 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. Over the last three years, China Railway Signal & Communication reported free cash flow worth 3.7% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that China Railway Signal & Communication has net cash of CN¥16.9b, as well as more liquid assets than liabilities. On top of that, it increased its EBIT by 13% in the last twelve months. So is China Railway Signal & Communication's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with China Railway Signal & Communication , and understanding them should be part of your investment process.

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.

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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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