Is China Energy Development Holdings (HKG:228) Using Debt In A Risky Way?

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 Energy Development Holdings Limited (HKG:228) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Energy Development Holdings

What Is China Energy Development Holdings's Debt?

As you can see below, China Energy Development Holdings had HK$113.5m of debt at June 2020, down from HK$184.6m a year prior. But on the other hand it also has HK$218.9m in cash, leading to a HK$105.4m net cash position.

How Strong Is China Energy Development Holdings's Balance Sheet?

We can see from the most recent balance sheet that China Energy Development Holdings had liabilities of HK$775.5m falling due within a year, and liabilities of HK$146.3m due beyond that. Offsetting this, it had HK$218.9m in cash and HK$109.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$593.5m.

This deficit isn't so bad because China Energy Development Holdings is worth HK$1.13b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, China Energy Development Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Over 12 months, China Energy Development Holdings made a loss at the EBIT level, and saw its revenue drop to HK$147m, which is a fall of 32%. To be frank that doesn't bode well.

So How Risky Is China Energy Development Holdings?

While China Energy Development Holdings lost money on an earnings before interest and tax (EBIT) level, it actually generated positive free cash flow HK$192m. So taking that on face value, and considering the net cash situation, we don't think that the stock is too risky in the near term. With revenue growth uninspiring, we'd really need to see some positive EBIT before mustering much enthusiasm for this business. When we look at a riskier company, we like to check how their profits (or losses) are trending over time. Today, we're providing readers this interactive graph showing how China Energy Development Holdings's profit, revenue, and operating cashflow have changed over the last few years.

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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