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

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.' 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 is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sichuan Expressway

What Is Sichuan Expressway's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Sichuan Expressway had CN¥37.8b of debt, an increase on CN¥20.8b, over one year. On the flip side, it has CN¥3.65b in cash leading to net debt of about CN¥34.1b.

How Strong Is Sichuan Expressway's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sichuan Expressway had liabilities of CN¥6.74b due within 12 months and liabilities of CN¥34.6b due beyond that. Offsetting this, it had CN¥3.65b in cash and CN¥961.6m in receivables that were due within 12 months. So it has liabilities totalling CN¥36.7b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥13.4b 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. At the end of the day, Sichuan Expressway would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 11.9, it's fair to say Sichuan Expressway does have a significant amount of debt. However, its interest coverage of 6.3 is reasonably strong, which is a good sign. One way Sichuan Expressway could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sichuan Expressway's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sichuan Expressway burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Sichuan Expressway's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Infrastructure industry companies like Sichuan Expressway commonly do use debt without problems. We're quite clear that we consider Sichuan Expressway to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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, we've discovered 2 warning signs for Sichuan Expressway (1 is significant!) that you should be aware of before investing here.

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. 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.