Legendary fund manager Li Lu (backed by Charlie Munger) once said, “The biggest investment risk is not price volatility, but if you suffer a permanent loss of capital.” When we think about how risky a company is, we always like to look at its debt utilization, as debt overload can lead to ruin. We note that Sinotrans Limited (HKG: 598) has a debt on its balance sheet. But is this debt a concern for shareholders?
What risk does debt entail?
Debt is a tool to help companies grow, but if a company is unable to repay its lenders, then it exists at their mercy. At worst, a company can go bankrupt if it fails to pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for businesses that need capital to invest in growth with high rates of return. The first thing to do when considering how much debt a company uses is to look at its liquidity and debt together.
View our latest analysis for Sinotrans
How much debt does sinotrans carry?
The chart below, which you can click on for more details, shows that Sinotrans had a debt of CN ¥ 13.2b as of September 2021; more or less like the year before. However, it has CN ¥ 12.8 billion in cash offsetting this, leading to net debt of around CN ¥ 394.2 million.
A look at the responsibilities of sinotrans
We can see from the most recent financial statements that Sinotrans had liabilities of CN ¥ 24.8b due within one year and liabilities of CN ¥ 15.2b due beyond. To compensate for this, it had CN ¥ 12.8 billion in cash and CN ¥ 18.8 billion in credits that would expire within 12 months. So it has liabilities totaling CN ¥ 8.31b more than its cash and short-term credits combined.
While that may sound like a lot, it’s not that bad since Sinotrans has a market cap of CN ¥ 29.8b, and so it could probably bolster its balance sheet by raising capital if needed. But it is clear that we should definitely look closely at whether he can manage his debt without dilution. Carrying virtually no net debt, Sinotrans really has a very light debt load.
We measure a company’s debt load versus its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) cover your interest expenses (interest coverage). Therefore we consider the payable related to the earnings both with and without depreciation and amortization expenses.
Sinotrans has a low debt / EBITDA ratio of only 0.10. And surprisingly, despite having a net debt, in the past twelve months he has actually received more interest than he should have paid. So there is no question that this company can get into debt by staying cool as a cucumber. Another good sign is that Sinotrans was able to increase its EBIT by 24% in twelve months, making it easier to pay off the debt. When analyzing debt levels, the budget is the obvious starting point. But ultimately the company’s future profitability will decide whether Sinotrans can strengthen its balance sheet over time. So, if you want to see what the pros are thinking, you might find this free analyst earnings forecast report interesting.
But our final consideration is also important, because a company cannot pay its debt with paper profits; he needs cold cash. So we need to clearly examine whether that EBIT is leading to a corresponding free cash flow. Over the past three years, Sinotrans has recorded free cash flow equal to 84% of its EBIT, which is stronger than we would normally expect. This puts him in a very strong position to pay off the debt.
Our point of view
The good news is that Sinotrans’s demonstrated ability to cover her passive interests with her EBIT delights us like a fluffy puppy does a baby. And this is just the beginning of some good news as its conversion of EBIT to free cash flow is also very encouraging. Considering this range of factors, it seems to us that Sinotrans is fairly cautious with its debt and the risks appear to be well managed. So the balance seems pretty healthy to us. The budget is clearly the area to focus on when analyzing debt. However, not all investment risk lies within the balance sheet, far from it. Keep in mind that Sinotrans is showing 1 red flag in our investment analysis you should know about …
If you are interested in investing in companies that can increase profits without the burden of debt, check this out free list of growing companies that have net liquidity on their balance sheets.
Do you have feedback on this article? Worried about the content? Get in touch directly with us. Alternatively, email the editorial team (at) simplywallst.com.
This Simply Wall St article 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 stock and does not take into account your goals or financial situation. Our goal is to provide you with a focused, long-term analysis driven by fundamental data. Please note that our analysis may not take into account the latest price sensitive company announcements or quality material. Simply Wall St has no position in any of the stocks mentioned.