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 can see that Hebei Construction Group Corporation Limited (HKG:1727) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Hebei Construction Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Hebei Construction Group had CN¥5.30b of debt, an increase on CN¥4.03b, over one year. But it also has CN¥5.47b in cash to offset that, meaning it has CN¥160.7m net cash.
How Strong Is Hebei Construction Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hebei Construction Group had liabilities of CN¥53.3b due within 12 months and liabilities of CN¥1.59b due beyond that. Offsetting this, it had CN¥5.47b in cash and CN¥49.4b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Hebei Construction Group's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥7.74b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Hebei Construction Group has more cash than debt is arguably a good indication that it can manage its debt safely.
Importantly, Hebei Construction Group's EBIT fell a jaw-dropping 37% 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 it is future earnings, more than anything, that will determine Hebei Construction Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Hebei Construction Group 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. In the last three years, Hebei Construction Group created free cash flow amounting to 13% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
While it is always sensible to investigate a company's debt, in this case Hebei Construction Group has CN¥160.7m in net cash and a decent-looking balance sheet. So while Hebei Construction Group does not have a great balance sheet, it's certainly not too bad. 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. For example, we've discovered 5 warning signs for Hebei Construction Group (2 don't sit too well with us!) that you should be aware of before investing here.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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