Zhejiang Expressway (HKG:576) Has A Somewhat Strained Balance Sheet

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, Zhejiang Expressway Co., Ltd. (HKG:576) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Zhejiang Expressway

How Much Debt Does Zhejiang Expressway Carry?

The image below, which you can click on for greater detail, shows that at March 2021 Zhejiang Expressway had debt of CN¥27.0b, up from CN¥23.0b in one year. However, because it has a cash reserve of CN¥12.9b, its net debt is less, at about CN¥14.1b.

How Healthy Is Zhejiang Expressway's Balance Sheet?

We can see from the most recent balance sheet that Zhejiang Expressway had liabilities of CN¥86.7b falling due within a year, and liabilities of CN¥27.4b due beyond that. Offsetting these obligations, it had cash of CN¥12.9b as well as receivables valued at CN¥22.4b due within 12 months. So it has liabilities totalling CN¥78.8b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥24.5b 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'd watch its balance sheet closely, without a doubt. After all, Zhejiang 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zhejiang Expressway's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 3.8 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Zhejiang Expressway grew its EBIT by 72% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zhejiang 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Zhejiang Expressway created free cash flow amounting to 2.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Mulling over Zhejiang Expressway's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Zhejiang Expressway is in the Infrastructure industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Zhejiang Expressway stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. We've identified 2 warning signs with Zhejiang Expressway (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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.
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