Here's Why China Hongqiao Group (HKG:1378) Can Manage Its Debt Responsibly

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. Importantly, China Hongqiao Group Limited (HKG:1378) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Hongqiao Group

What Is China Hongqiao Group's Debt?

You can click the graphic below for the historical numbers, but it shows that China Hongqiao Group had CN¥66.6b of debt in June 2021, down from CN¥80.7b, one year before. However, because it has a cash reserve of CN¥52.3b, its net debt is less, at about CN¥14.3b.

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¥66.7b falling due within a year, and liabilities of CN¥34.4b due beyond that. On the other hand, it had cash of CN¥52.3b and CN¥19.5b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥29.2b.

While this might seem like a lot, it is not so bad since China Hongqiao Group has a huge market capitalization of CN¥87.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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 Hongqiao Group's low debt to EBITDA ratio of 0.48 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.6 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Better yet, China Hongqiao Group grew its EBIT by 113% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, China Hongqiao Group recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

China Hongqiao Group's EBIT growth rate 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 net debt to EBITDA is also very heartening. Taking all this data into account, it seems to us that China Hongqiao Group takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that China Hongqiao Group is showing 4 warning signs in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.
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