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. As with many other companies Shoucheng Holdings Limited (HKG:697) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Shoucheng Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that Shoucheng Holdings had HK$793.2m of debt in December 2023, down from HK$1.05b, one year before. However, it does have HK$5.19b in cash offsetting this, leading to net cash of HK$4.39b.
How Healthy Is Shoucheng Holdings' Balance Sheet?
The latest balance sheet data shows that Shoucheng Holdings had liabilities of HK$1.33b due within a year, and liabilities of HK$2.15b falling due after that. Offsetting this, it had HK$5.19b in cash and HK$203.6m in receivables that were due within 12 months. So it actually has HK$1.91b more liquid assets than total liabilities.
This surplus suggests that Shoucheng Holdings is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Shoucheng Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
Unfortunately, Shoucheng Holdings saw its EBIT slide 5.1% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shoucheng Holdings 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Shoucheng Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Shoucheng Holdings burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Shoucheng Holdings has net cash of HK$4.39b, as well as more liquid assets than liabilities. So we are not troubled with Shoucheng Holdings's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. 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 1 warning sign for Shoucheng Holdings you should know about.
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.
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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.