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 Zhong Ao Home Group Limited (HKG:1538) does use debt in its business. But is this debt a concern to shareholders?
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. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Zhong Ao Home Group Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Zhong Ao Home Group had CN¥167.6m of debt, an increase on CN¥99.7m, over one year. However, its balance sheet shows it holds CN¥418.4m in cash, so it actually has CN¥250.8m net cash.
How Strong Is Zhong Ao Home Group's Balance Sheet?
The latest balance sheet data shows that Zhong Ao Home Group had liabilities of CN¥1.00b due within a year, and liabilities of CN¥153.1m falling due after that. Offsetting these obligations, it had cash of CN¥418.4m as well as receivables valued at CN¥488.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥247.0m.
While this might seem like a lot, it is not so bad since Zhong Ao Home Group has a market capitalization of CN¥503.0m, 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. While it does have liabilities worth noting, Zhong Ao Home Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
On the other hand, Zhong Ao Home Group saw its EBIT drop by 6.3% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is Zhong Ao Home Group's earnings that will influence how the balance sheet holds up in the future. 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. Zhong Ao Home Group 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. Over the most recent three years, Zhong Ao Home Group recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While Zhong Ao Home Group does have more liabilities than liquid assets, it also has net cash of CN¥250.8m. The cherry on top was that in converted 70% of that EBIT to free cash flow, bringing in CN¥114m. So we don't have any problem with Zhong Ao Home Group's use of debt. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Zhong Ao Home Group's dividend history, without delay!
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.
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