Is China Hongguang Holdings (HKG:8646) Using Too Much Debt?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that China Hongguang Holdings Limited (HKG:8646) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Hongguang Holdings

What Is China Hongguang Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 China Hongguang Holdings had CN¥76.5m of debt, an increase on CN¥38.0m, over one year. However, it also had CN¥61.4m in cash, and so its net debt is CN¥15.1m.

How Strong Is China Hongguang Holdings' Balance Sheet?

The latest balance sheet data shows that China Hongguang Holdings had liabilities of CN¥107.1m due within a year, and liabilities of CN¥12.2m falling due after that. Offsetting these obligations, it had cash of CN¥61.4m as well as receivables valued at CN¥81.2m due within 12 months. So it can boast CN¥23.3m more liquid assets than total liabilities.

This surplus suggests that China Hongguang Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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). 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).

China Hongguang Holdings's net debt is only 0.27 times its EBITDA. And its EBIT covers its interest expense a whopping 20.0 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, China Hongguang Holdings grew its EBIT by 84% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since China Hongguang 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Hongguang Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, China Hongguang Holdings's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Taking all this data into account, it seems to us that China Hongguang Holdings takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with China Hongguang Holdings (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.