Is China Hongguang Holdings (HKG:8646) A Risky Investment?

Warren Buffett famously said, '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 Hongguang Holdings Limited (HKG:8646) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

View our latest analysis for China Hongguang Holdings

What Is China Hongguang Holdings's Net Debt?

As you can see below, at the end of December 2021, China Hongguang Holdings had CN¥53.2m of debt, up from CN¥44.0m a year ago. Click the image for more detail. On the flip side, it has CN¥12.9m in cash leading to net debt of about CN¥40.3m.

A Look At China Hongguang Holdings' Liabilities

The latest balance sheet data shows that China Hongguang Holdings had liabilities of CN¥112.7m due within a year, and liabilities of CN¥10.7m falling due after that. Offsetting this, it had CN¥12.9m in cash and CN¥138.1m in receivables that were due within 12 months. So it can boast CN¥27.7m more liquid assets than total liabilities.

This excess liquidity suggests that China Hongguang Holdings is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Hongguang Holdings has a low net debt to EBITDA ratio of only 0.74. And its EBIT easily covers its interest expense, being 15.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, China Hongguang Holdings grew its EBIT by 201% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is China Hongguang Holdings's earnings that will influence how the balance sheet holds up in the future. 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's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Hongguang Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

The good news is that China Hongguang Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at the bigger picture, we think China Hongguang Holdings's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for China Hongguang Holdings (of which 1 is concerning!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.