Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies China Gas Holdings Limited (HKG:384) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does China Gas Holdings Carry?
The image below, which you can click on for greater detail, shows that at March 2019 China Gas Holdings had debt of HK$37.9b, up from HK$32.4b in one year. However, it also had HK$13.2b in cash, and so its net debt is HK$24.7b.
How Strong Is China Gas Holdings's Balance Sheet?
According to the last reported balance sheet, China Gas Holdings had liabilities of HK$46.6b due within 12 months, and liabilities of HK$22.5b due beyond 12 months. On the other hand, it had cash of HK$13.2b and HK$19.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$36.3b.
While this might seem like a lot, it is not so bad since China Gas Holdings has a huge market capitalization of HK$169.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a debt to EBITDA ratio of 2.2, China Gas Holdings uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.8 times interest expense) certainly does not do anything to dispel this impression. It is well worth noting that China Gas Holdings's EBIT shot up like bamboo after rain, gaining 31% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Gas Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China Gas Holdings reported free cash flow worth 10% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
China Gas Holdings's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. It's also worth noting that China Gas Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Looking at all the aforementioned factors together, it strikes us that China Gas Holdings can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that China Gas Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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