Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Shenzhen Expressway Corporation Limited (HKG:548) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Shenzhen Expressway Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Shenzhen Expressway had CN¥32.9b of debt, an increase on CN¥31.0b, over one year. On the flip side, it has CN¥3.66b in cash leading to net debt of about CN¥29.3b.

How Strong Is Shenzhen Expressway's Balance Sheet?

According to the last reported balance sheet, Shenzhen Expressway had liabilities of CN¥19.7b due within 12 months, and liabilities of CN¥19.3b due beyond 12 months. Offsetting this, it had CN¥3.66b in cash and CN¥2.09b in receivables that were due within 12 months. So its liabilities total CN¥33.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥20.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Shenzhen Expressway would likely require a major re-capitalisation if it had to pay its creditors today.

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.

As it happens Shenzhen Expressway has a fairly concerning net debt to EBITDA ratio of 6.0 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! We saw Shenzhen Expressway grow its EBIT by 6.8% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Shenzhen Expressway can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Shenzhen Expressway produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Neither Shenzhen Expressway's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. It's also worth noting that Shenzhen Expressway is in the Infrastructure industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that Shenzhen Expressway 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. Be aware that Shenzhen Expressway is showing 2 warning signs in our investment analysis , and 1 of those is significant...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com