Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Hao Tian International Construction Investment Group Limited (HKG:1341) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Hao Tian International Construction Investment Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Hao Tian International Construction Investment Group had HK$335.0m of debt, an increase on HK$83.4m, over one year. However, because it has a cash reserve of HK$237.0m, its net debt is less, at about HK$98.0m.
How Healthy Is Hao Tian International Construction Investment Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hao Tian International Construction Investment Group had liabilities of HK$240.0m due within 12 months and liabilities of HK$249.0m due beyond that. On the other hand, it had cash of HK$237.0m and HK$427.0m worth of receivables due within a year. So it can boast HK$175.0m more liquid assets than total liabilities.
This surplus suggests that Hao Tian International Construction Investment Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Hao Tian International Construction Investment Group has a very low debt to EBITDA ratio of 1.3 so it is strange to see weak interest coverage, with last year's EBIT being only 0.80 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Hao Tian International Construction Investment Group improved its EBIT from a last year's loss to a positive HK$27m. 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 Hao Tian International Construction Investment Group will need earnings to service that debt. 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Hao Tian International Construction Investment Group 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.
Both Hao Tian International Construction Investment Group's conversion of EBIT to free cash flow and its interest cover were discouraging. At least its level of total liabilities gives us reason to be optimistic. Taking the abovementioned factors together we do think Hao Tian International Construction Investment Group'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. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Hao Tian International Construction Investment Group (of which 1 can't be ignored!) you should know about.
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.
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