Is Shenzhen Energy Group (SZSE:000027) Taking Too Much Debt?

External fund manager Li Lu, backed by Berkshire Hathaway’s Charlie Munger, makes no bones about it when he says: “The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.” When you think about it, how If a particular stock is risky, it may be obvious that you need to consider debt, because too much debt can sink a company. As with many other companies Shenzhen Energy Group Co., Ltd. (SZSE:000027) exploits debt. But should shareholders be concerned about the use of debt?

Why does debt pose risks?

Debt is a tool that helps companies grow. However, if a company is unable to repay its lenders, it is at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, it is more common (but still costly) for a company to have to issue shares at bargain prices, resulting in permanent shareholder dilution, just to shore up its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high returns. When we think about a company’s use of debt, we first consider cash and debt together.

Check out our latest analysis for Shenzhen Energy Group

What is Shenzhen Energy Group’s net debt?

As you can see below, Shenzhen Energy Group had CN¥76.6 billion of debt as of September 2024, which is about the same as the year before. For more details you can click on the chart. However, since the company has a cash reserve of CN¥19.5 billion, its net debt is lower, at about CN¥57.0 billion.

A look at Shenzhen Energy Group’s liabilities

If we take a closer look at the latest balance sheet data, we can see that Shenzhen Energy Group had liabilities of CN¥35.3b in 12 months and liabilities of CN¥70.6b beyond that. Offsetting these obligations, it had cash of CN¥19.5b as well as receivables valued at CN¥15.8b due within 12 months. So its liabilities total CN¥70.6b more than the combination of its cash and short-term receivables.

This shortage weighs heavily on the CN¥31.7 billion company itself, as if a child were struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. So we definitely think shareholders should keep a close eye on this. Finally, Shenzhen Energy Group would likely need a major recapitalization if it had to pay its creditors today.

To measure a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Therefore, we look at debt relative to earnings both with and without depreciation charges.

With a net debt to EBITDA ratio of 5.5, it’s fair to say that Shenzhen Energy Group has a significant amount of debt. However, the good news is that its interest coverage is quite comfortable at 3.4x, suggesting it can meet its obligations responsibly. What may also be concerning for investors is that Shenzhen Energy Group suffered a 17% decline in EBIT over the last twelve months. If this continues, dealing with debt will be about as easy as packing an angry house cat into its travel crate. When analyzing debt levels, the balance sheet is the obvious place to start. But you can’t look at debt in complete isolation; as Shenzhen Energy Group will need revenue to service this debt. So if you’re interested in discovering more about the company’s earnings, it might be worth checking out this graph of its long-term earnings trend.

And finally, while the tax officer is happy about accounting profits, lenders only accept cold hard cash. So the logical step is to examine the proportion of that EBIT that corresponds to actual free cash flow. Over the past three years, Shenzhen Energy Group has experienced significantly negative free cash flow overall. While this may be due to growth spending, it makes debt significantly riskier.

Our view

To be honest, both Shenzhen Energy Group’s conversion of EBIT to free cash flow and its track record of keeping its total liabilities under control make us rather uncomfortable with its debt levels. And the EBIT growth rate doesn’t inspire confidence either. Considering everything we’ve mentioned above, it’s fair to say that Shenzhen Energy Group is carrying a heavy debt load. If you play with fire, you run the risk of getting burned. That’s why we’d probably give this stock a wide berth. There is no doubt that the balance sheet is where we learn the most about debt. However, not all investment risks lie on the balance sheet – quite the opposite. Note that Shenzhen Energy Group is performing 5 warning signs in our investment analysis and 3 of them concern…

If you’re interested in investing in companies that can grow profits without the burden of debt, then check this out free List of growing companies that have net cash on the balance sheet.

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This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts using only an unbiased methodology and our articles are not intended as financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term focused analysis based on fundamental data. Note that our analysis may not reflect the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.