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Here's Why Anhui Honglu Steel Construction(Group) (SZSE:002541) Is Weighed Down By Its Debt Load

アンハイ洪露鋼鉄建設(グループ)(SZSE:002541)が負債重荷に苦しんでいる理由はここにあります

Simply Wall St ·  08/14 18:13

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Anhui Honglu Steel Construction(Group) CO., LTD (SZSE:002541) does carry debt. But is this debt a concern to shareholders?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

What Is Anhui Honglu Steel Construction(Group)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Anhui Honglu Steel Construction(Group) had CN¥7.41b of debt, an increase on CN¥6.45b, over one year. However, because it has a cash reserve of CN¥1.56b, its net debt is less, at about CN¥5.85b.

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SZSE:002541 Debt to Equity History August 14th 2024

How Strong Is Anhui Honglu Steel Construction(Group)'s Balance Sheet?

We can see from the most recent balance sheet that Anhui Honglu Steel Construction(Group) had liabilities of CN¥8.30b falling due within a year, and liabilities of CN¥6.09b due beyond that. Offsetting this, it had CN¥1.56b in cash and CN¥3.14b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥9.70b.

Given this deficit is actually higher than the company's market capitalization of CN¥9.16b, we think shareholders really should watch Anhui Honglu Steel Construction(Group)'s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Anhui Honglu Steel Construction(Group) has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 4.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Another concern for investors might be that Anhui Honglu Steel Construction(Group)'s EBIT fell 18% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Anhui Honglu Steel Construction(Group)'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Anhui Honglu Steel Construction(Group) 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 Anhui Honglu Steel Construction(Group)'s EBIT growth rate and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. After considering the datapoints discussed, we think Anhui Honglu Steel Construction(Group) has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 Anhui Honglu Steel Construction(Group) is showing 3 warning signs in our investment analysis , and 1 of those is potentially serious...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.

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