Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Shenzhen Huakong Seg Co., Ltd. (SZSE:000068) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Shenzhen Huakong Seg's Debt?
As you can see below, Shenzhen Huakong Seg had CN¥1.53b of debt at September 2023, down from CN¥1.70b a year prior. However, it does have CN¥232.5m in cash offsetting this, leading to net debt of about CN¥1.30b.
How Healthy Is Shenzhen Huakong Seg's Balance Sheet?
According to the last reported balance sheet, Shenzhen Huakong Seg had liabilities of CN¥2.14b due within 12 months, and liabilities of CN¥1.18b due beyond 12 months. Offsetting these obligations, it had cash of CN¥232.5m as well as receivables valued at CN¥890.1m due within 12 months. So its liabilities total CN¥2.20b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Shenzhen Huakong Seg has a market capitalization of CN¥3.99b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shenzhen Huakong Seg's earnings that will influence how the balance sheet holds up in the future. 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.
In the last year Shenzhen Huakong Seg had a loss before interest and tax, and actually shrunk its revenue by 29%, to CN¥864m. To be frank that doesn't bode well.
Caveat Emptor
While Shenzhen Huakong Seg's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost CN¥117m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Surprisingly, we note that it actually reported positive free cash flow of CN¥204m and a profit of CN¥205m. So if we focus on those metrics there seems to be a chance the company will manage its debt without much trouble. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Shenzhen Huakong Seg is showing 3 warning signs in our investment analysis , and 2 of those are potentially serious...
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.