Is GDS Holdings (NASDAQ:GDS) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that GDS Holdings Limited (NASDAQ:GDS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for GDS Holdings

What Is GDS Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2021 GDS Holdings had debt of CN¥16.0b, up from CN¥11.6b in one year. However, because it has a cash reserve of CN¥14.9b, its net debt is less, at about CN¥1.06b.

A Look At GDS Holdings' Liabilities

We can see from the most recent balance sheet that GDS Holdings had liabilities of CN¥7.68b falling due within a year, and liabilities of CN¥24.1b due beyond that. Offsetting these obligations, it had cash of CN¥14.9b as well as receivables valued at CN¥1.98b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥14.8b.

Of course, GDS Holdings has a titanic market capitalization of CN¥87.6b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, GDS Holdings has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

GDS Holdings has a very low debt to EBITDA ratio of 0.43 so it is strange to see weak interest coverage, with last year's EBIT being only 0.43 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. GDS Holdings grew its EBIT by 2.5% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 GDS Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, GDS Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Both GDS Holdings's conversion of EBIT to free cash flow and its interest cover were discouraging. But on the brighter side of life, its net debt to EBITDA leaves us feeling more frolicsome. When we consider all the factors discussed, it seems to us that GDS Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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 example, we've discovered 1 warning sign for GDS Holdings that you should be aware of before investing here.

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. 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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