Changsha Broad Homes Industrial Group (HKG:2163) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Changsha Broad Homes Industrial Group Co., Ltd. (HKG:2163) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Changsha Broad Homes Industrial Group

What Is Changsha Broad Homes Industrial Group's Net Debt?

As you can see below, at the end of December 2020, Changsha Broad Homes Industrial Group had CN¥2.98b of debt, up from CN¥2.62b a year ago. Click the image for more detail. On the flip side, it has CN¥828.3m in cash leading to net debt of about CN¥2.16b.

How Healthy Is Changsha Broad Homes Industrial Group's Balance Sheet?

The latest balance sheet data shows that Changsha Broad Homes Industrial Group had liabilities of CN¥3.91b due within a year, and liabilities of CN¥1.15b falling due after that. Offsetting these obligations, it had cash of CN¥828.3m as well as receivables valued at CN¥2.69b due within 12 months. So it has liabilities totalling CN¥1.53b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Changsha Broad Homes Industrial Group has a market capitalization of CN¥5.51b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Changsha Broad Homes Industrial Group's debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even worse, Changsha Broad Homes Industrial Group saw its EBIT tank 44% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Changsha Broad Homes Industrial Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Changsha Broad Homes Industrial Group actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

On the face of it, Changsha Broad Homes Industrial Group'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. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, it seems to us that Changsha Broad Homes Industrial Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Changsha Broad Homes Industrial Group has 5 warning signs (and 1 which is concerning) we think you should know about.

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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