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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Century City International Holdings Limited (HKG:355) does use debt in its business. 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 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Century City International Holdings’s Debt?
As you can see below, at the end of June 2019, Century City International Holdings had HK$20.2b of debt, up from HK$19.2b a year ago. Click the image for more detail. However, it also had HK$3.09b in cash, and so its net debt is HK$17.1b.
How Healthy Is Century City International Holdings’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Century City International Holdings had liabilities of HK$6.86b due within 12 months and liabilities of HK$17.2b due beyond that. Offsetting these obligations, it had cash of HK$3.09b as well as receivables valued at HK$854.1m due within 12 months. So it has liabilities totalling HK$20.1b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$1.89b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Century City International Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Century City International Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (14.0), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. This means we’d consider it to have a heavy debt load. Worse, Century City International Holdings’s EBIT was down 22% 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 it is Century City International 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Century City International Holdings reported free cash flow worth 8.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
To be frank both Century City 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. Considering everything we’ve mentioned above, it’s fair to say that Century City International Holdings is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we’d probably stay away from this particular stock. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Century City International Holdings’s dividend history, without delay!
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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