China Greenland Broad Greenstate Group (HKG:1253) Takes On Some Risk With Its Use Of Debt

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. We can see that China Greenland Broad Greenstate Group Company Limited (HKG:1253) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China Greenland Broad Greenstate Group

How Much Debt Does China Greenland Broad Greenstate Group Carry?

As you can see below, China Greenland Broad Greenstate Group had CN¥864.1m of debt at June 2020, down from CN¥1.06b a year prior. However, it also had CN¥563.5m in cash, and so its net debt is CN¥300.6m.

How Strong Is China Greenland Broad Greenstate Group's Balance Sheet?

The latest balance sheet data shows that China Greenland Broad Greenstate Group had liabilities of CN¥2.21b due within a year, and liabilities of CN¥276.0m falling due after that. On the other hand, it had cash of CN¥563.5m and CN¥1.76b worth of receivables due within a year. So it has liabilities totalling CN¥165.6m more than its cash and near-term receivables, combined.

Given China Greenland Broad Greenstate Group has a market capitalization of CN¥1.04b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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 Greenland Broad Greenstate Group shareholders face the double whammy of a high net debt to EBITDA ratio (5.6), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. The debt burden here is substantial. However, one redeeming factor is that China Greenland Broad Greenstate Group grew its EBIT at 15% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is China Greenland Broad Greenstate Group'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, China Greenland Broad Greenstate Group created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both China Greenland Broad Greenstate Group's interest cover and its net debt to EBITDA were discouraging. At least its EBIT growth rate gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that China Greenland Broad Greenstate Group 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for China Greenland Broad Greenstate Group (2 are significant!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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