CITIC Resources Holdings (HKG:1205) Takes On Some Risk With Its Use Of Debt

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, CITIC Resources Holdings Limited (HKG:1205) does carry debt. But should shareholders be worried about its use of debt?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for CITIC Resources Holdings

What Is CITIC Resources Holdings's Debt?

The image below, which you can click on for greater detail, shows that CITIC Resources Holdings had debt of HK$3.66b at the end of December 2021, a reduction from HK$4.88b over a year. On the flip side, it has HK$1.93b in cash leading to net debt of about HK$1.73b.

A Look At CITIC Resources Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that CITIC Resources Holdings had liabilities of HK$1.43b due within 12 months and liabilities of HK$4.36b due beyond that. Offsetting these obligations, it had cash of HK$1.93b as well as receivables valued at HK$704.9m due within 12 months. So its liabilities total HK$3.15b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$4.71b, so it does suggest shareholders should keep an eye on CITIC Resources Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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 CITIC Resources Holdings's moderate net debt to EBITDA ratio ( being 1.5), indicates prudence when it comes to debt. And its commanding EBIT of 13.0 times its interest expense, implies the debt load is as light as a peacock feather. Although CITIC Resources Holdings made a loss at the EBIT level, last year, it was also good to see that it generated HK$809m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is CITIC Resources Holdings'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, CITIC Resources Holdings actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

CITIC Resources Holdings's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think CITIC Resources Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for CITIC Resources Holdings that you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.