Yuexiu Transport Infrastructure (HKG:1052) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Yuexiu Transport Infrastructure Limited (HKG:1052) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that 1052 is potentially undervalued!

What Is Yuexiu Transport Infrastructure's Debt?

As you can see below, Yuexiu Transport Infrastructure had CN¥16.3b of debt at June 2022, down from CN¥17.8b a year prior. However, because it has a cash reserve of CN¥2.87b, its net debt is less, at about CN¥13.5b.

How Healthy Is Yuexiu Transport Infrastructure's Balance Sheet?

We can see from the most recent balance sheet that Yuexiu Transport Infrastructure had liabilities of CN¥6.84b falling due within a year, and liabilities of CN¥13.8b due beyond that. Offsetting these obligations, it had cash of CN¥2.87b as well as receivables valued at CN¥392.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥17.4b.

This deficit casts a shadow over the CN¥4.92b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Yuexiu Transport Infrastructure would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Yuexiu Transport Infrastructure's debt is 5.0 times its EBITDA, and its EBIT cover its interest expense 2.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even worse, Yuexiu Transport Infrastructure saw its EBIT tank 26% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Yuexiu Transport Infrastructure 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Yuexiu Transport Infrastructure actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Yuexiu Transport Infrastructure's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. It's also worth noting that Yuexiu Transport Infrastructure is in the Infrastructure industry, which is often considered to be quite defensive. We're quite clear that we consider Yuexiu Transport Infrastructure to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example Yuexiu Transport Infrastructure has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.

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. 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.