Is Shenzhen International Holdings (HKG:152) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Shenzhen International Holdings Limited (HKG:152) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Shenzhen International Holdings

What Is Shenzhen International Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Shenzhen International Holdings had HK$39.3b of debt, an increase on HK$31.3b, over one year. However, it does have HK$15.2b in cash offsetting this, leading to net debt of about HK$24.1b.

A Look At Shenzhen International Holdings' Liabilities

The latest balance sheet data shows that Shenzhen International Holdings had liabilities of HK$38.5b due within a year, and liabilities of HK$22.9b falling due after that. Offsetting these obligations, it had cash of HK$15.2b as well as receivables valued at HK$6.62b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$39.6b.

This deficit casts a shadow over the HK$18.3b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Shenzhen International Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

With a debt to EBITDA ratio of 2.5, Shenzhen International Holdings uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.9 times its interest expenses harmonizes with that theme. It is well worth noting that Shenzhen International Holdings's EBIT shot up like bamboo after rain, gaining 74% in the last twelve months. That'll make it easier to manage its debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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, Shenzhen International Holdings 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 Shenzhen International Holdings's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. 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 balance sheet and taking into account all these factors, we do believe that debt is making Shenzhen International Holdings stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 instance, we've identified 5 warning signs for Shenzhen International Holdings (1 doesn't sit too well with us) you should be aware of.

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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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.