Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Shenzhen HeungKong Holding Co.,Ltd (SHSE:600162) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Shenzhen HeungKong HoldingLtd Carry?

The image below, which you can click on for greater detail, shows that Shenzhen HeungKong HoldingLtd had debt of CN¥3.33b at the end of December 2023, a reduction from CN¥5.52b over a year. However, it does have CN¥1.57b in cash offsetting this, leading to net debt of about CN¥1.77b.

How Healthy Is Shenzhen HeungKong HoldingLtd's Balance Sheet?

The latest balance sheet data shows that Shenzhen HeungKong HoldingLtd had liabilities of CN¥11.7b due within a year, and liabilities of CN¥2.13b falling due after that. Offsetting these obligations, it had cash of CN¥1.57b as well as receivables valued at CN¥731.8m due within 12 months. So it has liabilities totalling CN¥11.5b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥4.80b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Shenzhen HeungKong HoldingLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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

While Shenzhen HeungKong HoldingLtd has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 2.0. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. One way Shenzhen HeungKong HoldingLtd could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is Shenzhen HeungKong HoldingLtd's earnings that will influence how the balance sheet holds up in the future. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Shenzhen HeungKong HoldingLtd produced sturdy free cash flow equating to 77% 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

To be frank both Shenzhen HeungKong HoldingLtd's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Shenzhen HeungKong HoldingLtd stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 Shenzhen HeungKong HoldingLtd is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.