U.S. Markets closed

Is HC Group (HKG:2280) A Risky Investment?

Simply Wall St

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that HC Group Inc. (HKG:2280) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for HC Group

What Is HC Group's Net Debt?

As you can see below, at the end of June 2019, HC Group had CN¥2.53b of debt, up from CN¥1.71b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥450.3m, its net debt is less, at about CN¥2.08b.

SEHK:2280 Historical Debt, September 26th 2019

How Healthy Is HC Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that HC Group had liabilities of CN¥2.35b due within 12 months and liabilities of CN¥1.49b due beyond that. On the other hand, it had cash of CN¥450.3m and CN¥2.36b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.03b.

While this might seem like a lot, it is not so bad since HC Group has a market capitalization of CN¥3.18b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

HC Group shareholders face the double whammy of a high net debt to EBITDA ratio (10.5), and fairly weak interest coverage, since EBIT is just 0.039 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, HC Group saw its EBIT tank 98% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if HC Group 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, HC Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, HC Group's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn't such a worry. After considering the datapoints discussed, we think HC Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about HC Group's debt levels, it seems only prudent to check if insiders have been ditching the stock.

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

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.