These 4 Measures Indicate That Sichuan Expressway (HKG:107) Is Using Debt In A Risky Way

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Sichuan Expressway Company Limited (HKG:107) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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?

As you can see below, Sichuan Expressway had CN¥19.8b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥2.90b in cash offsetting this, leading to net debt of about CN¥16.9b.

How Healthy Is Sichuan Expressway's Balance Sheet?

We can see from the most recent balance sheet that Sichuan Expressway had liabilities of CN¥4.18b falling due within a year, and liabilities of CN¥17.9b due beyond that. On the other hand, it had cash of CN¥2.90b and CN¥1.77b worth of receivables due within a year. 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¥7.51b 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.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Strangely Sichuan Expressway has a sky high EBITDA ratio of 7.0, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Sichuan Expressway's EBIT fell a jaw-dropping 39% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Sichuan Expressway will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding 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

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 on the bright side, its interest cover is a good sign, and makes us more optimistic. 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. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example Sichuan Expressway has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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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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.