Huazhang Technology Holding (HKG:1673) Has A Somewhat Strained Balance Sheet

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Huazhang Technology Holding Limited (HKG:1673) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Huazhang Technology Holding

How Much Debt Does Huazhang Technology Holding Carry?

As you can see below, at the end of December 2020, Huazhang Technology Holding had CN¥203.1m of debt, up from CN¥166.6m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥84.2m, its net debt is less, at about CN¥119.0m.

How Healthy Is Huazhang Technology Holding's Balance Sheet?

According to the last reported balance sheet, Huazhang Technology Holding had liabilities of CN¥663.9m due within 12 months, and liabilities of CN¥68.7m due beyond 12 months. Offsetting these obligations, it had cash of CN¥84.2m as well as receivables valued at CN¥512.5m due within 12 months. So its liabilities total CN¥135.9m more than the combination of its cash and short-term receivables.

Since publicly traded Huazhang Technology Holding shares are worth a total of CN¥1.14b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

As it happens Huazhang Technology Holding has a fairly concerning net debt to EBITDA ratio of 6.2 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Huazhang Technology Holding's EBIT fell a jaw-dropping 82% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Huazhang Technology Holding'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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Huazhang Technology Holding burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Huazhang Technology Holding's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Huazhang Technology Holding's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Huazhang Technology Holding (1 is significant) 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.

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