Is Shenzhen Investment Holdings Bay Area Development (HKG:737) 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.' 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. As with many other companies Shenzhen Investment Holdings Bay Area Development Company Limited (HKG:737) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shenzhen Investment Holdings Bay Area Development

How Much Debt Does Shenzhen Investment Holdings Bay Area Development Carry?

The image below, which you can click on for greater detail, shows that at December 2022 Shenzhen Investment Holdings Bay Area Development had debt of CN¥3.96b, up from CN¥1.94b in one year. However, because it has a cash reserve of CN¥940.5m, its net debt is less, at about CN¥3.02b.

How Strong Is Shenzhen Investment Holdings Bay Area Development's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shenzhen Investment Holdings Bay Area Development had liabilities of CN¥1.88b due within 12 months and liabilities of CN¥2.96b due beyond that. Offsetting these obligations, it had cash of CN¥940.5m as well as receivables valued at CN¥532.5m due within 12 months. So its liabilities total CN¥3.36b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥4.97b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely Shenzhen Investment Holdings Bay Area Development has a sky high EBITDA ratio of 25.8, implying high debt, but a strong interest coverage of 10.8. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, Shenzhen Investment Holdings Bay Area Development made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥112m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shenzhen Investment Holdings Bay Area Development'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 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, Shenzhen Investment Holdings Bay Area Development burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Shenzhen Investment Holdings Bay Area Development's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow 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 Investment Holdings Bay Area Development is in the Infrastructure industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Shenzhen Investment Holdings Bay Area Development's debt is making it 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. For example Shenzhen Investment Holdings Bay Area Development has 4 warning signs (and 3 which are a bit unpleasant) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.