Is Shenzhen Expressway (HKG:548) A Risky Investment?

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.' 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. As with many other companies Shenzhen Expressway Corporation Limited (HKG:548) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out the opportunities and risks within the HK Infrastructure industry.

What Is Shenzhen Expressway's Debt?

As you can see below, at the end of June 2022, Shenzhen Expressway had CN¥34.9b of debt, up from CN¥22.6b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥6.39b, its net debt is less, at about CN¥28.5b.

How Healthy Is Shenzhen Expressway's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Expressway had liabilities of CN¥20.2b falling due within a year, and liabilities of CN¥23.8b due beyond that. Offsetting these obligations, it had cash of CN¥6.39b as well as receivables valued at CN¥2.38b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥35.2b.

This deficit casts a shadow over the CN¥15.0b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Shenzhen Expressway would probably need a major re-capitalization if its creditors were to demand repayment.

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.

With a net debt to EBITDA ratio of 5.8, it's fair to say Shenzhen Expressway does have a significant amount of debt. However, its interest coverage of 6.3 is reasonably strong, which is a good sign. Importantly, Shenzhen Expressway's EBIT fell a jaw-dropping 26% 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 it is future earnings, more than anything, that will determine Shenzhen Expressway's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shenzhen Expressway 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

To be frank both Shenzhen 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 at least its interest cover is not so bad. It's also worth noting that Shenzhen Expressway is in the Infrastructure industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Shenzhen Expressway has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Be aware that Shenzhen Expressway is showing 4 warning signs in our investment analysis , and 1 of those 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.