Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies China Infrastructure & Logistics Group Ltd. (HKG:1719) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses 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 and debt together.
What Is China Infrastructure & Logistics Group's Net Debt?
The image below, which you can click on for greater detail, shows that China Infrastructure & Logistics Group had debt of HK$486.0m at the end of June 2019, a reduction from HK$517.5m over a year. On the flip side, it has HK$35.1m in cash leading to net debt of about HK$450.8m.
How Healthy Is China Infrastructure & Logistics Group's Balance Sheet?
The latest balance sheet data shows that China Infrastructure & Logistics Group had liabilities of HK$486.7m due within a year, and liabilities of HK$300.4m falling due after that. On the other hand, it had cash of HK$35.1m and HK$135.9m worth of receivables due within a year. So it has liabilities totalling HK$616.1m more than its cash and near-term receivables, combined.
China Infrastructure & Logistics Group has a market capitalization of HK$1.38b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
China Infrastructure & Logistics Group shareholders face the double whammy of a high net debt to EBITDA ratio (6.4), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. The debt burden here is substantial. Fortunately, China Infrastructure & Logistics Group grew its EBIT by 5.3% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Infrastructure & Logistics Group 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, China Infrastructure & Logistics Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both China Infrastructure & Logistics Group's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It's also worth noting that China Infrastructure & Logistics Group is in the Infrastructure industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that China Infrastructure & Logistics Group's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Over time, share prices tend to follow earnings per share, so if you're interested in China Infrastructure & Logistics Group, you may well want to click here to check an interactive graph of its earnings per share history.
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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