Here's Why Changsha Broad Homes Industrial Group (HKG:2163) Has A Meaningful Debt Burden

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. Importantly, Changsha Broad Homes Industrial Group Co., Ltd. (HKG:2163) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Changsha Broad Homes Industrial Group

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

The image below, which you can click on for greater detail, shows that at December 2020 Changsha Broad Homes Industrial Group had debt of CN¥2.98b, up from CN¥2.62b in one year. On the flip side, it has CN¥828.3m in cash leading to net debt of about CN¥2.16b.

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

Zooming in on the latest balance sheet data, we can see that Changsha Broad Homes Industrial Group had liabilities of CN¥3.91b due within 12 months and liabilities of CN¥1.15b due beyond that. Offsetting these obligations, it had cash of CN¥828.3m as well as receivables valued at CN¥2.61b due within 12 months. So its liabilities total CN¥1.61b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Changsha Broad Homes Industrial Group has a market capitalization of CN¥6.84b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Changsha Broad Homes Industrial Group's debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 2.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, Changsha Broad Homes Industrial Group's EBIT was down 40% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Changsha Broad Homes Industrial Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

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. But at least its level of total liabilities is not so bad. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Changsha Broad Homes Industrial Group (1 is a bit unpleasant!) that you should be aware of before investing here.

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.

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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. 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.
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