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We Think China Communications Services (HKG:552) Can Manage Its Debt With Ease

Simply Wall St

Warren Buffett famously said, '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. We note that China Communications Services Corporation Limited (HKG:552) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for China Communications Services

What Is China Communications Services's Debt?

The image below, which you can click on for greater detail, shows that at June 2019 China Communications Services had debt of CN¥475.9m, up from CN¥408.1m in one year. But it also has CN¥20.7b in cash to offset that, meaning it has CN¥20.2b net cash.

SEHK:552 Historical Debt, February 13th 2020

How Strong Is China Communications Services's Balance Sheet?

The latest balance sheet data shows that China Communications Services had liabilities of CN¥49.8b due within a year, and liabilities of CN¥2.15b falling due after that. On the other hand, it had cash of CN¥20.7b and CN¥38.0b worth of receivables due within a year. So it can boast CN¥6.76b more liquid assets than total liabilities.

This excess liquidity suggests that China Communications Services is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, China Communications Services boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, China Communications Services's EBIT dived 10%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Communications Services's ability to maintain a healthy balance sheet going forward. 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. China Communications Services may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, China Communications Services actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to investigate a company's debt, in this case China Communications Services has CN¥20.2b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 125% of that EBIT to free cash flow, bringing in CN¥2.0b. So is China Communications Services's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for China Communications Services you should be aware of.

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.

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.

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. Thank you for reading.