These 4 Measures Indicate That China Energy Development Holdings (HKG:228) Is Using Debt Extensively

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.' 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 is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See 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 2022 China Energy Development Holdings had HK$593.9m of debt, an increase on HK$551.0m, over one year. On the flip side, it has HK$160.2m in cash leading to net debt of about HK$433.7m.

How Healthy Is China Energy Development Holdings' Balance Sheet?

According to the last reported balance sheet, China Energy Development Holdings had liabilities of HK$543.9m due within 12 months, and liabilities of HK$289.6m due beyond 12 months. On the other hand, it had cash of HK$160.2m and HK$32.4m worth of receivables due within a year. So it has liabilities totalling HK$641.0m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$779.4m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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 2.0 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. Unfortunately, China Energy Development Holdings saw its EBIT slide 6.1% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Energy Development Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over China Energy Development Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its net debt to EBITDA 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for China Energy Development Holdings you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.