Shenzhen International Holdings (HKG:152) Seems To Be Using A Lot Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Shenzhen International Holdings Limited (HKG:152) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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.

Check out our latest analysis for Shenzhen International Holdings

What Is Shenzhen International Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Shenzhen International Holdings had debt of HK$57.7b, up from HK$53.4b in one year. However, it also had HK$15.3b in cash, and so its net debt is HK$42.4b.

A Look At Shenzhen International Holdings' Liabilities

The latest balance sheet data shows that Shenzhen International Holdings had liabilities of HK$48.6b due within a year, and liabilities of HK$29.7b falling due after that. Offsetting these obligations, it had cash of HK$15.3b as well as receivables valued at HK$5.84b due within 12 months. So its liabilities total HK$57.2b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$16.6b 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. 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).

Shenzhen International Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (7.4), and fairly weak interest coverage, since EBIT is just 2.2 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Shenzhen International Holdings's EBIT was down 27% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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. Over the last three years, Shenzhen International Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Shenzhen International Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. It's also worth noting that Shenzhen International Holdings is in the Infrastructure industry, which is often considered to be quite defensive. It looks to us like Shenzhen International Holdings carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. To that end, you should learn about the 5 warning signs we've spotted with Shenzhen International Holdings (including 1 which is significant) .

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. 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.