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. We can see that CIG ShangHai Co., Ltd. (SHSE:603083) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is CIG ShangHai's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2024 CIG ShangHai had debt of CN¥1.48b, up from CN¥968.0m in one year. However, because it has a cash reserve of CN¥745.2m, its net debt is less, at about CN¥733.5m.
How Strong Is CIG ShangHai's Balance Sheet?
We can see from the most recent balance sheet that CIG ShangHai had liabilities of CN¥2.64b falling due within a year, and liabilities of CN¥254.3m due beyond that. On the other hand, it had cash of CN¥745.2m and CN¥1.21b worth of receivables due within a year. So its liabilities total CN¥942.4m more than the combination of its cash and short-term receivables.
Given CIG ShangHai has a market capitalization of CN¥9.40b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Weak interest cover of 0.89 times and a disturbingly high net debt to EBITDA ratio of 5.3 hit our confidence in CIG ShangHai like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, CIG ShangHai's EBIT was down 90% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since CIG ShangHai 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, CIG ShangHai saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
On the face of it, CIG ShangHai's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. We're quite clear that we consider CIG ShangHai to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for CIG ShangHai you should be aware of.
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.