Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
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. As with many other companies. China Communications Construction Company Limited (HKG:1800) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 China Communications Construction’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 China Communications Construction had CN¥293.5b of debt, an increase on CN¥273.1b, over one year. However, it also had CN¥105.8b in cash, and so its net debt is CN¥187.7b.
How Strong Is China Communications Construction’s Balance Sheet?
We can see from the most recent balance sheet that China Communications Construction had liabilities of CN¥466.9b falling due within a year, and liabilities of CN¥259.2b due beyond that. Offsetting this, it had CN¥105.8b in cash and CN¥221.5b in receivables that were due within 12 months. So its liabilities total CN¥398.8b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CN¥157.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, China Communications Construction would probably need a major re-capitalization if its creditors were to demand repayment. Since China Communications Construction does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
China Communications Construction has a debt to EBITDA ratio of 4.83 and its EBIT covered its interest expense 6.81 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. We saw China Communications Construction grow its EBIT by 2.1% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Communications Construction can strengthen its balance sheet over time. 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Communications Construction 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.
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 at least it’s pretty decent at covering its interest expense with its EBIT; that’s encouraging. After considering the datapoints discussed, we think China Communications Construction has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check China Communications Construction’s dividend history, without delay!
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.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. Thank you for reading.