Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Sichuan Expressway Company Limited (HKG:107) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Sichuan Expressway's Debt?

As you can see below, at the end of September 2024, Sichuan Expressway had CN¥39.8b of debt, up from CN¥37.8b a year ago. Click the image for more detail. However, it also had CN¥2.71b in cash, and so its net debt is CN¥37.1b.

How Strong Is Sichuan Expressway's Balance Sheet?

We can see from the most recent balance sheet that Sichuan Expressway had liabilities of CN¥6.84b falling due within a year, and liabilities of CN¥36.4b due beyond that. On the other hand, it had cash of CN¥2.71b and CN¥620.4m worth of receivables due within a year. So it has liabilities totalling CN¥39.9b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥14.2b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Sichuan 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). 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).

Sichuan Expressway has a rather high debt to EBITDA ratio of 10.2 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.0 times, suggesting it can responsibly service its obligations. Notably, Sichuan Expressway's EBIT was pretty flat over the last year, which isn't ideal given the debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sichuan Expressway will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Sichuan Expressway burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Sichuan Expressway's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It's also worth noting that Sichuan Expressway is in the Infrastructure industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Sichuan Expressway 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 Sichuan Expressway (of which 1 shouldn't be ignored!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.