China Energy Development Holdings (HKG:228) Has A Somewhat Strained Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies China Energy Development Holdings Limited (HKG:228) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Energy Development Holdings

What Is China Energy Development Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 China Energy Development Holdings had HK$506.9m of debt, an increase on HK$108.8m, over one year. However, it also had HK$204.3m in cash, and so its net debt is HK$302.6m.

How Healthy Is China Energy Development Holdings' Balance Sheet?

We can see from the most recent balance sheet that China Energy Development Holdings had liabilities of HK$664.6m falling due within a year, and liabilities of HK$481.4m due beyond that. Offsetting this, it had HK$204.3m in cash and HK$130.8m in receivables that were due within 12 months. So its liabilities total HK$810.9m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$960.0m, so it does suggest shareholders should keep an eye on China Energy Development Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Weak interest cover of 0.26 times and a disturbingly high net debt to EBITDA ratio of 5.8 hit our confidence in China Energy Development Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that China Energy Development Holdings achieved a positive EBIT of HK$6.0m in the last twelve months, an improvement on the prior year's loss. 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 Energy Development 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, China Energy Development Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both China Energy Development Holdings's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We're quite clear that we consider China Energy Development Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Case in point: We've spotted 1 warning sign for China Energy Development Holdings you should be aware of.

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. 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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