Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Yuan Heng Gas Holdings Limited (HKG:332) does use debt in its business. But should shareholders be worried about its use of debt?
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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Yuan Heng Gas Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Yuan Heng Gas Holdings had debt of CN¥1.38b, up from CN¥622.7m in one year. However, it also had CN¥75.2m in cash, and so its net debt is CN¥1.31b.
How Healthy Is Yuan Heng Gas Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Yuan Heng Gas Holdings had liabilities of CN¥2.76b due within 12 months and liabilities of CN¥356.4m due beyond that. Offsetting this, it had CN¥75.2m in cash and CN¥2.61b in receivables that were due within 12 months. So its liabilities total CN¥428.2m more than the combination of its cash and short-term receivables.
Since publicly traded Yuan Heng Gas Holdings shares are worth a total of CN¥3.02b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 7.1, it's fair to say Yuan Heng Gas Holdings does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.0 times, suggesting it can responsibly service its obligations. Worse, Yuan Heng Gas Holdings's EBIT was down 22% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Yuan Heng Gas Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Yuan Heng Gas Holdings 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.
To be frank both Yuan Heng Gas Holdings's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Yuan Heng Gas Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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