Sichuan Expressway (HKG:107) Seems To Be Using A Lot Of Debt

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.' 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. We note that Sichuan Expressway Company Limited (HKG:107) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sichuan Expressway

What Is Sichuan Expressway's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Sichuan Expressway had debt of CN¥18.0b, up from CN¥17.0b in one year. However, it does have CN¥3.64b in cash offsetting this, leading to net debt of about CN¥14.3b.

How Healthy Is Sichuan Expressway's Balance Sheet?

According to the last reported balance sheet, Sichuan Expressway had liabilities of CN¥9.90b due within 12 months, and liabilities of CN¥13.5b due beyond 12 months. On the other hand, it had cash of CN¥3.64b and CN¥1.03b worth of receivables due within a year. So its liabilities total CN¥18.7b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥8.29b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Sichuan Expressway would probably need a major re-capitalization if its creditors were to demand repayment.

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. 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 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 it's worth checking how much of that EBIT is backed by 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. It's also worth noting that Sichuan Expressway is in the Infrastructure industry, which is often considered to be quite defensive. 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Sichuan Expressway (including 2 which shouldn't be ignored) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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