Here's Why Shenzhen International Holdings (HKG:152) Has A Meaningful Debt Burden

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Shenzhen International Holdings Limited (HKG:152) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Shenzhen International Holdings

How Much Debt Does Shenzhen International Holdings Carry?

The image below, which you can click on for greater detail, shows that at June 2020 Shenzhen International Holdings had debt of HK$31.3b, up from HK$26.7b in one year. On the flip side, it has HK$11.8b in cash leading to net debt of about HK$19.5b.

How Healthy Is Shenzhen International Holdings's Balance Sheet?

According to the last reported balance sheet, Shenzhen International Holdings had liabilities of HK$21.9b due within 12 months, and liabilities of HK$30.0b due beyond 12 months. Offsetting this, it had HK$11.8b in cash and HK$7.25b in receivables that were due within 12 months. So its liabilities total HK$32.9b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's HK$27.1b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Shenzhen International Holdings's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 5.8 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. If Shenzhen International Holdings can keep growing EBIT at last year's rate of 10% over the last year, then it will find its debt load easier to manage. 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 Shenzhen International Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Shenzhen International Holdings recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Mulling over Shenzhen International Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Infrastructure industry companies like Shenzhen International Holdings commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Shenzhen International Holdings's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Shenzhen International Holdings you should be aware of, and 2 of them are a bit concerning.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. 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.
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