The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Shanghai Lujiazui Finance & Trade Zone Development Co.,Ltd. (SHSE:600663) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2023 Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd had CN¥74.7b of debt, an increase on CN¥58.9b, over one year. However, it also had CN¥11.2b in cash, and so its net debt is CN¥63.5b.
How Healthy Is Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's Balance Sheet?
We can see from the most recent balance sheet that Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd had liabilities of CN¥66.0b falling due within a year, and liabilities of CN¥47.5b due beyond that. On the other hand, it had cash of CN¥11.2b and CN¥2.03b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥100.3b.
The deficiency here weighs heavily on the CN¥34.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd shareholders face the double whammy of a high net debt to EBITDA ratio (17.8), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. The debt burden here is substantial. Worse, Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's EBIT was down 27% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
On the face of it, Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Shanghai Lujiazui Finance & Trade Zone DevelopmentLtd (2 don't sit too well with us!) that you should be aware of before investing here.
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.