Does China Hongqiao Group (HKG:1378) 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.' 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 China Hongqiao Group Limited (HKG:1378) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Hongqiao Group

How Much Debt Does China Hongqiao Group Carry?

You can click the graphic below for the historical numbers, but it shows that China Hongqiao Group had CN¥60.4b of debt in December 2021, down from CN¥74.8b, one year before. However, because it has a cash reserve of CN¥49.2b, its net debt is less, at about CN¥11.1b.

How Healthy Is China Hongqiao Group's Balance Sheet?

We can see from the most recent balance sheet that China Hongqiao Group had liabilities of CN¥63.1b falling due within a year, and liabilities of CN¥32.9b due beyond that. Offsetting this, it had CN¥49.2b in cash and CN¥23.1b in receivables that were due within 12 months. So its liabilities total CN¥23.6b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since China Hongqiao Group has a huge market capitalization of CN¥74.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt sitting at just 0.36 times EBITDA, China Hongqiao Group is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.3 times the interest expense over the last year. On top of that, China Hongqiao Group grew its EBIT by 62% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Hongqiao Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, China Hongqiao Group generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

China Hongqiao Group's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think China Hongqiao Group's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with China Hongqiao Group .

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.