China Communications Construction (HKG:1800) Use Of Debt Could Be Considered Risky

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that China Communications Construction Company Limited (HKG:1800) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Communications Construction

How Much Debt Does China Communications Construction Carry?

As you can see below, China Communications Construction had CN¥438.6b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥129.4b in cash offsetting this, leading to net debt of about CN¥309.2b.

A Look At China Communications Construction's Liabilities

The latest balance sheet data shows that China Communications Construction had liabilities of CN¥647.9b due within a year, and liabilities of CN¥427.0b falling due after that. Offsetting these obligations, it had cash of CN¥129.4b as well as receivables valued at CN¥301.7b due within 12 months. So it has liabilities totalling CN¥643.9b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥118.7b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Communications Construction would likely require a major re-capitalisation if it had to pay its creditors today.

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 China Communications Construction has a fairly concerning net debt to EBITDA ratio of 6.4 but very strong interest coverage of 11.2. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably China Communications Construction's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Communications Construction can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, China Communications Construction saw substantial negative free cash flow, in total. 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, China Communications Construction's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like China Communications Construction has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for China Communications Construction you should be aware of, and 1 of them is significant.

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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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.