Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Hebei Construction Group Corporation Limited (HKG:1727) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for Hebei Construction Group
What Is Hebei Construction Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 Hebei Construction Group had CN¥5.28b of debt, an increase on CN¥3.48b, over one year. But it also has CN¥8.61b in cash to offset that, meaning it has CN¥3.32b net cash.
A Look At Hebei Construction Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Hebei Construction Group had liabilities of CN¥53.4b due within 12 months and liabilities of CN¥2.15b due beyond that. Offsetting these obligations, it had cash of CN¥8.61b as well as receivables valued at CN¥47.4b due within 12 months. So these liquid assets roughly match the total liabilities.
This short term liquidity is a sign that Hebei Construction Group could probably pay off its debt with ease, as its balance sheet is far from stretched. 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.
In fact Hebei Construction Group's saving grace is its low debt levels, because its EBIT has tanked 38% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hebei Construction 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. 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. Over the last three years, Hebei Construction Group barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
Summing up
While it is always sensible to investigate a company's debt, in this case Hebei Construction Group has CN¥3.32b 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. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Hebei Construction Group (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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