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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that China Glass Holdings Limited (HKG:3300) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is China Glass Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2020 China Glass Holdings had debt of CN¥3.80b, up from CN¥3.19b in one year. However, it does have CN¥814.5m in cash offsetting this, leading to net debt of about CN¥2.98b.
A Look At China Glass Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that China Glass Holdings had liabilities of CN¥4.42b due within 12 months and liabilities of CN¥1.19b due beyond that. Offsetting this, it had CN¥814.5m in cash and CN¥854.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥3.94b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥549.2m 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'd watch its balance sheet closely, without a doubt. After all, China Glass Holdings 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 0.13 times and a disturbingly high net debt to EBITDA ratio of 11.4 hit our confidence in China Glass Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for China Glass Holdings is that it turned last year's EBIT loss into a gain of CN¥26m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Glass Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, China Glass Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both China Glass Holdings's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Considering all the factors previously mentioned, we think that China Glass Holdings really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. Be aware that China Glass Holdings is showing 2 warning signs in our investment analysis , you should know about...
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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