The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, Zhong Hua International Holdings Limited (HKG:1064) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Zhong Hua International Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Zhong Hua International Holdings had HK$76.6m of debt in June 2019, down from HK$86.2m, one year before. But on the other hand it also has HK$82.4m in cash, leading to a HK$5.80m net cash position.
A Look At Zhong Hua International Holdings’s Liabilities
The latest balance sheet data shows that Zhong Hua International Holdings had liabilities of HK$110.7m due within a year, and liabilities of HK$1.32b falling due after that. Offsetting this, it had HK$82.4m in cash and HK$19.8m in receivables that were due within 12 months. So it has liabilities totalling HK$1.32b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$120.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Zhong Hua International Holdings would probably need a major re-capitalization if its creditors were to demand repayment. Given that Zhong Hua International Holdings has more cash than debt, we’re pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
Importantly, Zhong Hua International Holdings grew its EBIT by 47% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Zhong Hua International Holdings will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Zhong Hua International Holdings has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Zhong Hua International Holdings actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Although Zhong Hua International Holdings’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$5.80m. The cherry on top was that in converted 127% of that EBIT to free cash flow, bringing in HK$35m. So we don’t have any problem with Zhong Hua International Holdings’s use of debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We’ve identified 5 warning signs with Zhong Hua International Holdings (at least 1 which is concerning) , and understanding them should be part of your investment process.
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 firstname.lastname@example.org. 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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