These 4 Measures Indicate That Chinlink International Holdings (HKG:997) Is Using Debt In A Risky Way

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Chinlink International Holdings Limited (HKG:997) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Chinlink International Holdings

What Is Chinlink International Holdings's Net Debt?

The chart below, which you can click on for greater detail, shows that Chinlink International Holdings had HK$1.99b in debt in September 2020; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Chinlink International Holdings's Balance Sheet?

The latest balance sheet data shows that Chinlink International Holdings had liabilities of HK$2.24b due within a year, and liabilities of HK$861.1m falling due after that. On the other hand, it had cash of HK$30.2m and HK$314.0m worth of receivables due within a year. So its liabilities total HK$2.76b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$116.9m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Chinlink International Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Chinlink International Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (207), and fairly weak interest coverage, since EBIT is just 0.018 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Chinlink International Holdings's EBIT was down 94% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Chinlink International Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. During the last three years, Chinlink International 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

To be frank both Chinlink International Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It looks to us like Chinlink International Holdings carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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. Take risks, for example - Chinlink International Holdings has 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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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