Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu doesn’t care when he says, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital ”. When we think about the risk level of a business, we always like to look at its use of debt, because debt overload can lead to bankruptcy. We can see that Chengdu Expressway Co., Ltd. (HKG: 1785) uses debt in its business. But the most important question is: what is the risk that this debt creates?
What risk does debt entail?
Debt helps a business until it struggles to pay it off, either with new capital or free cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest review for Chengdu Expressway
What is the debt of Chengdu Expressway?
The image below, which you can click for more details, shows that in December 2020, Chengdu Expressway had a debt of CNY 3.26 billion, compared to CNY 3.04 billion in a year. On the other hand, he has 1.77 billion yen in cash, which leads to net debt of around 1.50 billion yen.
How strong is Chengdu Expressway’s balance sheet?
The latest balance sheet data shows that Chengdu Expressway had commitments of 1.51 billion yen due in one year and commitments of 3.39 billion yen due thereafter. In return for these obligations, he had cash of 1.77 billion yen as well as receivables valued at 70.5 million yen, due within 12 months. Its liabilities therefore total 3.06 billion yen more than the combination of its cash and short-term receivables.
If you consider this shortfall to exceed the company’s 3.04 billion yen market capitalization, you might be inclined to take a close look at the balance sheet. In theory, an extremely large dilution would be necessary if the company were forced to repay its debts by raising capital at the current share price.
In order to size a company’s debt against its profit, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest expense. (its interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
Chengdu Expressway’s net debt stands at a very reasonable level of 1.9 times its EBITDA, while its EBIT only covered its interest expense 4.3 times last year. While these numbers do not alarm us, it should be noted that the cost of the company’s debt does have a real impact. Importantly, Chengdu Expressway’s EBIT fell 34% in the past twelve months. If this earnings trend continues, paying off debt will be about as easy as raising cats on a roller coaster. There is no doubt that we learn the most about debt from the balance sheet. But it is the profits of Chengdu Expressway that will influence the balance sheet in the future. So if you want to know more about its earnings, it might be worth checking out this chart of its long term trend.
Finally, while the tax authorities love accounting profits, lenders only accept cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Chengdu Expressway has actually produced more free cash flow than EBIT. This kind of big cash conversion turns us on as much as the crowd when the beat drops at a Daft Punk concert.
Our point of view
Chengdu Expressway’s EBIT growth rate and total liability level is certainly weighing on it, in our opinion. But the good news is that it seems to be able to easily convert EBIT into free cash flow. We should also note that infrastructure sector companies like Chengdu Expressway generally use debt without problems. Taking the above-mentioned factors together, we believe that Chengdu Expressway’s debt poses certain risks for the business. While this debt can increase returns, we believe the company now has sufficient leverage. When analyzing debt levels, the balance sheet is the obvious place to start. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 2 warning signs for the Chengdu highway which you should be aware of before investing here.
If, after all of this, you’re more interested in a fast-growing company with a rock-solid balance sheet, then take a quick look at our list of cash-growing stocks.
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