Sinotrans (HKG:598) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Sinotrans Limited (HKG:598) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Sinotrans

What Is Sinotrans's Debt?

The image below, which you can click on for greater detail, shows that Sinotrans had debt of CN¥12.3b at the end of September 2023, a reduction from CN¥14.0b over a year. But on the other hand it also has CN¥14.8b in cash, leading to a CN¥2.45b net cash position.

How Healthy Is Sinotrans' Balance Sheet?

The latest balance sheet data shows that Sinotrans had liabilities of CN¥32.8b due within a year, and liabilities of CN¥8.02b falling due after that. Offsetting these obligations, it had cash of CN¥14.8b as well as receivables valued at CN¥18.8b due within 12 months. So its liabilities total CN¥7.27b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Sinotrans is worth CN¥33.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Sinotrans also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Sinotrans's load is not too heavy, because its EBIT was down 21% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Sinotrans'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Sinotrans may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Sinotrans generated free cash flow amounting to a very robust 100% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

Although Sinotrans's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥2.45b. The cherry on top was that in converted 100% of that EBIT to free cash flow, bringing in CN¥1.8b. So we are not troubled with Sinotrans's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Sinotrans you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.