We Think Yuan Heng Gas Holdings (HKG:332) Is Taking Some Risk With Its Debt

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Yuan Heng Gas Holdings Limited (HKG:332) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Yuan Heng Gas Holdings

What Is Yuan Heng Gas Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Yuan Heng Gas Holdings had CN¥1.21b of debt in March 2021, down from CN¥1.56b, one year before. On the flip side, it has CN¥53.9m in cash leading to net debt of about CN¥1.16b.

A Look At Yuan Heng Gas Holdings' Liabilities

The latest balance sheet data shows that Yuan Heng Gas Holdings had liabilities of CN¥1.94b due within a year, and liabilities of CN¥193.4m falling due after that. Offsetting these obligations, it had cash of CN¥53.9m as well as receivables valued at CN¥1.44b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥644.6m.

Yuan Heng Gas Holdings has a market capitalization of CN¥2.26b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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 we wouldn't worry about Yuan Heng Gas Holdings's net debt to EBITDA ratio of 4.3, we think its super-low interest cover of 2.4 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that Yuan Heng Gas Holdings actually grew its EBIT by a hefty 559%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Yuan Heng Gas 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, Yuan Heng Gas 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

Yuan Heng Gas Holdings's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Yuan Heng Gas Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 3 warning signs with Yuan Heng Gas Holdings (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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