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 note that CNNC International Limited (HKG:2302) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does CNNC International Carry?
As you can see below, at the end of June 2019, CNNC International had HK$396.5m of debt, up from HK$117.0k a year ago. Click the image for more detail. However, it does have HK$59.4m in cash offsetting this, leading to net debt of about HK$337.1m.
A Look At CNNC International’s Liabilities
We can see from the most recent balance sheet that CNNC International had liabilities of HK$215.7m falling due within a year, and liabilities of HK$288.4m due beyond that. Offsetting this, it had HK$59.4m in cash and HK$67.8m in receivables that were due within 12 months. So its liabilities total HK$376.9m more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because CNNC International is worth HK$1.36b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
CNNC International has a rather high debt to EBITDA ratio of 32.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. One redeeming factor for CNNC International is that it turned last year’s EBIT loss into a gain of HK$9.8m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is CNNC International’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 it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, CNNC International actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
CNNC International’s net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There’s no doubt that its ability to to convert EBIT to free cash flow is pretty flash. Looking at all this data makes us feel a little cautious about CNNC International’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example – CNNC International has 1 warning sign we think you should be aware of.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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