Is Shanghai Dazhong Public Utilities(Group)Ltd (SHSE:600635) Using Too Much Debt?

Simply Wall St ·  Feb 12 18:43

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.' 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 can see that Shanghai Dazhong Public Utilities(Group) Co.,Ltd. (SHSE:600635) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Shanghai Dazhong Public Utilities(Group)Ltd's Debt?

The chart below, which you can click on for greater detail, shows that Shanghai Dazhong Public Utilities(Group)Ltd had CN¥8.21b in debt in September 2023; about the same as the year before. However, it does have CN¥3.18b in cash offsetting this, leading to net debt of about CN¥5.03b.

SHSE:600635 Debt to Equity History February 12th 2024

A Look At Shanghai Dazhong Public Utilities(Group)Ltd's Liabilities

The latest balance sheet data shows that Shanghai Dazhong Public Utilities(Group)Ltd had liabilities of CN¥8.02b due within a year, and liabilities of CN¥5.11b falling due after that. Offsetting this, it had CN¥3.18b in cash and CN¥418.2m in receivables that were due within 12 months. So its liabilities total CN¥9.53b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CN¥7.64b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

As it happens Shanghai Dazhong Public Utilities(Group)Ltd has a fairly concerning net debt to EBITDA ratio of 8.5 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! Also relevant is that Shanghai Dazhong Public Utilities(Group)Ltd has grown its EBIT by a very respectable 23% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shanghai Dazhong Public Utilities(Group)Ltd 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.

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, Shanghai Dazhong Public Utilities(Group)Ltd generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Shanghai Dazhong Public Utilities(Group)Ltd's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. It's also worth noting that Shanghai Dazhong Public Utilities(Group)Ltd is in the Gas Utilities industry, which is often considered to be quite defensive. Considering this range of data points, we think Shanghai Dazhong Public Utilities(Group)Ltd is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 Shanghai Dazhong Public Utilities(Group)Ltd has 4 warning signs (and 3 which are significant) we think you should know about.

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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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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