Is China State Construction International Holdings (HKG:3311) Using Too Much Debt?

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. We can see that China State Construction International Holdings Limited (HKG:3311) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China State Construction International Holdings

What Is China State Construction International Holdings's Debt?

As you can see below, China State Construction International Holdings had HK$59.5b of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$21.5b in cash leading to net debt of about HK$38.0b.

How Strong Is China State Construction International Holdings' Balance Sheet?

We can see from the most recent balance sheet that China State Construction International Holdings had liabilities of HK$79.8b falling due within a year, and liabilities of HK$52.1b due beyond that. Offsetting this, it had HK$21.5b in cash and HK$66.3b in receivables that were due within 12 months. So its liabilities total HK$44.1b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$44.3b, so it does suggest shareholders should keep an eye on China State Construction International Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 State Construction International Holdings has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 4.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, China State Construction International Holdings's EBIT was pretty flat over the last year, which isn't ideal given the debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China State Construction International Holdings's ability to maintain a healthy balance sheet going forward. 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 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.

Our View

We'd go so far as to say China State Construction International Holdings's conversion of EBIT to free cash flow was disappointing. But at least its EBIT growth rate is not so bad. We're quite clear that we consider China State Construction International Holdings to be really rather risky, as a result of its balance sheet health. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for China State Construction International Holdings (of which 1 is a bit unpleasant!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.