Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, China Electronics Huada Technology Company Limited (HKG:85) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does China Electronics Huada Technology Carry?
As you can see below, China Electronics Huada Technology had HK$2.29b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of HK$571.6m, its net debt is less, at about HK$1.71b.
How Healthy Is China Electronics Huada Technology's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Electronics Huada Technology had liabilities of HK$2.96b due within 12 months and liabilities of HK$77.6m due beyond that. On the other hand, it had cash of HK$571.6m and HK$1.03b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.44b.
When you consider that this deficiency exceeds the company's HK$1.36b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
In order to size up 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.86 times and a disturbingly high net debt to EBITDA ratio of 15.3 hit our confidence in China Electronics Huada Technology like a one-two punch to the gut. The debt burden here is substantial. Another concern for investors might be that China Electronics Huada Technology's EBIT fell 19% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Electronics Huada Technology 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 always check how much of that EBIT is translated into free cash flow. During the last three years, China Electronics Huada Technology burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both China Electronics Huada Technology's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And even its EBIT growth rate fails to inspire much confidence. Considering all the factors previously mentioned, we think that China Electronics Huada Technology really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. Given China Electronics Huada Technology has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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