Here's Why Sichuan Expressway (HKG:107) Is Weighed Down By Its Debt Load

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Sichuan Expressway Company Limited (HKG:107) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

Check out our latest analysis for Sichuan Expressway

What Is Sichuan Expressway's Debt?

As you can see below, at the end of September 2020, Sichuan Expressway had CN¥18.0b of debt, up from CN¥17.0b a year ago. Click the image for more detail. However, it also had CN¥3.64b in cash, and so its net debt is CN¥14.3b.

How Strong Is Sichuan Expressway's Balance Sheet?

We can see from the most recent balance sheet that Sichuan Expressway had liabilities of CN¥9.90b falling due within a year, and liabilities of CN¥13.5b due beyond that. On the other hand, it had cash of CN¥3.64b and CN¥1.03b worth of receivables due within a year. So it has liabilities totalling CN¥18.7b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥8.89b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Sichuan Expressway 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.

Sichuan Expressway shareholders face the double whammy of a high net debt to EBITDA ratio (7.7), and fairly weak interest coverage, since EBIT is just 1.8 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Sichuan Expressway's EBIT was down 49% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sichuan Expressway'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.

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. Looking at the most recent three years, Sichuan Expressway recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Sichuan Expressway'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 its conversion of EBIT to free cash flow is not so bad. We should also note that Infrastructure industry companies like Sichuan Expressway commonly do use debt without problems. Taking into account all the aforementioned factors, it looks like Sichuan Expressway has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Sichuan Expressway (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

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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