Stock Analysis

Is Shenzhen Expressway (HKG:548) Using Too Much Debt?

SEHK:548
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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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Shenzhen Expressway Corporation Limited (HKG:548) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

See our latest analysis for Shenzhen Expressway

What Is Shenzhen Expressway's Net Debt?

As you can see below, Shenzhen Expressway had CN¥31.0b of debt at March 2023, down from CN¥34.4b a year prior. However, it also had CN¥5.02b in cash, and so its net debt is CN¥26.0b.

debt-equity-history-analysis
SEHK:548 Debt to Equity History May 26th 2023

How Healthy Is Shenzhen Expressway's Balance Sheet?

We can see from the most recent balance sheet that Shenzhen Expressway had liabilities of CN¥22.5b falling due within a year, and liabilities of CN¥18.4b due beyond that. Offsetting this, it had CN¥5.02b in cash and CN¥2.05b in receivables that were due within 12 months. So its liabilities total CN¥33.9b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥17.8b 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 Expressway would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Strangely Shenzhen Expressway has a sky high EBITDA ratio of 5.7, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Unfortunately, Shenzhen Expressway's EBIT flopped 13% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. 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, 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. In the last three years, Shenzhen Expressway created free cash flow amounting to 12% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Shenzhen Expressway's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Shenzhen Expressway is in the Infrastructure industry, which is often considered to be quite defensive. Overall, it seems to us that Shenzhen Expressway's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 example Shenzhen Expressway has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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.

Valuation is complex, but we're helping make it simple.

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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.