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David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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. We note that China State Construction International Holdings Limited (HKG:3311) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does China State Construction International Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 China State Construction International Holdings had HK$41.0b of debt, an increase on HK$33.3b, over one year. However, it does have HK$18.2b in cash offsetting this, leading to net debt of about HK$22.9b.
A Look At China State Construction International Holdings’s Liabilities
According to the last reported balance sheet, China State Construction International Holdings had liabilities of HK$53.6b due within 12 months, and liabilities of HK$39.4b due beyond 12 months. On the other hand, it had cash of HK$18.2b and HK$38.7b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$36.1b.
This is a mountain of leverage relative to its market capitalization of HK$40.3b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Since China State Construction International Holdings does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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.
China State Construction International Holdings has a debt to EBITDA ratio of 2.98 and its EBIT covered its interest expense 5.04 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. One way China State Construction International Holdings could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 17%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China State Construction International Holdings 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China State Construction International Holdings 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.
We’d go so far as to say China State Construction International Holdings’s conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China State Construction International Holdings stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check China State Construction International Holdings’s dividend history, without delay!
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.