Prinx Chengshan Holdings (HKG:1809) Has A Somewhat Strained Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Prinx Chengshan Holdings Limited (HKG:1809) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Prinx Chengshan Holdings

What Is Prinx Chengshan Holdings's Net Debt?

As you can see below, at the end of December 2021, Prinx Chengshan Holdings had CN¥1.90b of debt, up from CN¥665.2m a year ago. Click the image for more detail. However, it also had CN¥849.0m in cash, and so its net debt is CN¥1.05b.

A Look At Prinx Chengshan Holdings' Liabilities

We can see from the most recent balance sheet that Prinx Chengshan Holdings had liabilities of CN¥3.54b falling due within a year, and liabilities of CN¥1.71b due beyond that. Offsetting this, it had CN¥849.0m in cash and CN¥1.49b in receivables that were due within 12 months. So its liabilities total CN¥2.91b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥3.44b, so it does suggest shareholders should keep an eye on Prinx Chengshan Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

We'd say that Prinx Chengshan Holdings's moderate net debt to EBITDA ratio ( being 2.3), indicates prudence when it comes to debt. And its strong interest cover of 32.7 times, makes us even more comfortable. Importantly, Prinx Chengshan Holdings's EBIT fell a jaw-dropping 65% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Prinx Chengshan Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Prinx Chengshan Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Prinx Chengshan 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. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Prinx Chengshan 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. 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. We've identified 3 warning signs with Prinx Chengshan Holdings , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.