Here's Why China Energy Development Holdings (HKG:228) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that China Energy Development Holdings Limited (HKG:228) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for China Energy Development Holdings

How Much Debt Does China Energy Development Holdings Carry?

The image below, which you can click on for greater detail, shows that China Energy Development Holdings had debt of HK$336.7m at the end of June 2024, a reduction from HK$578.0m over a year. However, it does have HK$61.7m in cash offsetting this, leading to net debt of about HK$275.0m.

How Strong 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$245.2m falling due within a year, and liabilities of HK$258.7m due beyond that. On the other hand, it had cash of HK$61.7m and HK$109.1m worth of receivables due within a year. So it has liabilities totalling HK$333.1m more than its cash and near-term receivables, combined.

China Energy Development Holdings has a market capitalization of HK$863.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

While China Energy Development Holdings's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.4 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We saw China Energy Development Holdings grow its EBIT by 2.1% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Energy Development Holdings reported free cash flow worth 7.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

While China Energy Development Holdings's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. At least its net debt to EBITDA gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that China Energy Development Holdings 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. 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. Be aware that China Energy Development Holdings is showing 1 warning sign in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.