Is Shandong Hi-Speed New Energy Group (HKG:1250) 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. We note that Shandong Hi-Speed New Energy Group Limited (HKG:1250) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Shandong Hi-Speed New Energy Group

What Is Shandong Hi-Speed New Energy Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2023 Shandong Hi-Speed New Energy Group had debt of HK$28.3b, up from HK$25.3b in one year. However, it does have HK$3.75b in cash offsetting this, leading to net debt of about HK$24.6b.

How Healthy Is Shandong Hi-Speed New Energy Group's Balance Sheet?

The latest balance sheet data shows that Shandong Hi-Speed New Energy Group had liabilities of HK$12.2b due within a year, and liabilities of HK$23.7b falling due after that. Offsetting these obligations, it had cash of HK$3.75b as well as receivables valued at HK$9.65b due within 12 months. So it has liabilities totalling HK$22.5b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$5.84b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Shandong Hi-Speed New Energy Group would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 7.4 hit our confidence in Shandong Hi-Speed New Energy Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On a slightly more positive note, Shandong Hi-Speed New Energy Group grew its EBIT at 12% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But it is Shandong Hi-Speed New Energy Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Shandong Hi-Speed New Energy Group produced sturdy free cash flow equating to 50% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Shandong Hi-Speed New Energy Group's interest cover 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 EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Shandong Hi-Speed New Energy Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Shandong Hi-Speed New Energy Group .

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.