China State Construction Development Holdings (HKG:830) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies China State Construction Development Holdings Limited (HKG:830) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China State Construction Development Holdings

How Much Debt Does China State Construction Development Holdings Carry?

The image below, which you can click on for greater detail, shows that at December 2020 China State Construction Development Holdings had debt of HK$1.29b, up from HK$867.5m in one year. On the flip side, it has HK$1.05b in cash leading to net debt of about HK$245.4m.

How Healthy Is China State Construction Development Holdings' Balance Sheet?

According to the last reported balance sheet, China State Construction Development Holdings had liabilities of HK$4.65b due within 12 months, and liabilities of HK$1.42b due beyond 12 months. Offsetting these obligations, it had cash of HK$1.05b as well as receivables valued at HK$3.66b due within 12 months. So its liabilities total HK$1.36b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$1.62b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China State Construction Development Holdings has net debt of just 0.88 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.6 times the interest expense over the last year. But the other side of the story is that China State Construction Development Holdings saw its EBIT decline by 7.2% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China State Construction Development Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Looking at the most recent three years, China State Construction Development Holdings recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While China State Construction Development Holdings's level of total liabilities does give us pause, its interest cover and net debt to EBITDA suggest it can stay on top of its debt load. When we consider all the factors discussed, it seems to us that China State Construction Development Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should learn about the 3 warning signs we've spotted with China State Construction Development Holdings (including 1 which is significant) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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