Does China Energy Development Holdings (HKG:228) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies China Energy Development Holdings Limited (HKG:228) makes use of debt. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 June 2022 China Energy Development Holdings had HK$595.5m of debt, an increase on HK$514.8m, over one year. However, it also had HK$183.5m in cash, and so its net debt is HK$412.1m.

A Look At China Energy Development Holdings' Liabilities

The latest balance sheet data shows that China Energy Development Holdings had liabilities of HK$476.0m due within a year, and liabilities of HK$519.6m falling due after that. Offsetting this, it had HK$183.5m in cash and HK$95.7m in receivables that were due within 12 months. So it has liabilities totalling HK$716.4m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$1.12b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Energy Development Holdings's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 2.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. One way China Energy Development Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is China Energy Development 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, China Energy Development Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say China Energy Development Holdings's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Energy Development Holdings stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for China Energy Development Holdings that you should be aware of before investing here.

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.