Is Shunfeng International Clean Energy (HKG:1165) Using Too Much Debt?

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.' 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. Importantly, Shunfeng International Clean Energy Limited (HKG:1165) does carry 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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Shunfeng International Clean Energy

What Is Shunfeng International Clean Energy's Debt?

You can click the graphic below for the historical numbers, but it shows that Shunfeng International Clean Energy had CN¥8.13b of debt in June 2021, down from CN¥9.74b, one year before. And it doesn't have much cash, so its net debt is about the same.

A Look At Shunfeng International Clean Energy's Liabilities

According to the last reported balance sheet, Shunfeng International Clean Energy had liabilities of CN¥7.02b due within 12 months, and liabilities of CN¥2.67b due beyond 12 months. Offsetting these obligations, it had cash of CN¥16.0m as well as receivables valued at CN¥3.29b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥6.39b.

The deficiency here weighs heavily on the CN¥430.2m 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, Shunfeng International Clean Energy would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Weak interest cover of 0.52 times and a disturbingly high net debt to EBITDA ratio of 12.6 hit our confidence in Shunfeng International Clean Energy like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Shunfeng International Clean Energy saw its EBIT tank 32% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shunfeng International Clean Energy will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shunfeng International Clean Energy actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Shunfeng International Clean Energy's EBIT growth rate 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 on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Shunfeng International Clean Energy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Shunfeng International Clean Energy 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.

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.

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