Is Shanyuan (GTSM:4416) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Shanyuan Co., Ltd. (GTSM:4416) does carry debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Shanyuan

What Is Shanyuan's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Shanyuan had NT$9.17b of debt, an increase on NT$8.17b, over one year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Shanyuan's Balance Sheet?

The latest balance sheet data shows that Shanyuan had liabilities of NT$6.31b due within a year, and liabilities of NT$3.06b falling due after that. Offsetting these obligations, it had cash of NT$54.5m as well as receivables valued at NT$285.1m due within 12 months. So it has liabilities totalling NT$9.02b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the NT$6.00b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Shanyuan 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.24 times and a disturbingly high net debt to EBITDA ratio of 159 hit our confidence in Shanyuan like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Shanyuan achieved a positive EBIT of NT$26m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shanyuan 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Shanyuan saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Shanyuan's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Shanyuan has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Shanyuan (2 don't sit too well with us) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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