Does Guangshen Railway (HKG:525) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that Guangshen Railway Company Limited (HKG:525) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Guangshen Railway

How Much Debt Does Guangshen Railway Carry?

As you can see below, at the end of September 2023, Guangshen Railway had CN¥1.49b of debt, up from CN¥700.0m a year ago. Click the image for more detail. On the flip side, it has CN¥1.43b in cash leading to net debt of about CN¥56.5m.

How Healthy Is Guangshen Railway's Balance Sheet?

We can see from the most recent balance sheet that Guangshen Railway had liabilities of CN¥7.75b falling due within a year, and liabilities of CN¥2.87b due beyond that. Offsetting this, it had CN¥1.43b in cash and CN¥6.39b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.81b.

Given Guangshen Railway has a market capitalization of CN¥16.5b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Guangshen Railway has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Guangshen Railway's debt of just 0.029 times EBITDA is clearly modest. But EBIT was only 1.5 times the interest expense last year, which shows that the debt has negatively impacted the business, by constraining its options (and restricting its free cash flow). We also note that Guangshen Railway improved its EBIT from a last year's loss to a positive CN¥82m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guangshen Railway 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Guangshen Railway burned a lot of cash. 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

Both Guangshen Railway's conversion of EBIT to free cash flow and its interest cover were discouraging. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Guangshen Railway's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 1 warning sign for Guangshen Railway that 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.