Here's Why China Gas Industry Investment Holdings (HKG:1940) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, China Gas Industry Investment Holdings Co. Ltd. (HKG:1940) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Gas Industry Investment Holdings

How Much Debt Does China Gas Industry Investment Holdings Carry?

The image below, which you can click on for greater detail, shows that China Gas Industry Investment Holdings had debt of CN¥533.0m at the end of December 2023, a reduction from CN¥572.5m over a year. On the flip side, it has CN¥282.3m in cash leading to net debt of about CN¥250.7m.

How Strong Is China Gas Industry Investment Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Gas Industry Investment Holdings had liabilities of CN¥668.2m due within 12 months and liabilities of CN¥291.3m due beyond that. Offsetting these obligations, it had cash of CN¥282.3m as well as receivables valued at CN¥543.9m due within 12 months. So it has liabilities totalling CN¥133.3m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since China Gas Industry Investment Holdings has a market capitalization of CN¥521.0m, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt sitting at just 0.79 times EBITDA, China Gas Industry Investment Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.8 times the interest expense over the last year. The good news is that China Gas Industry Investment Holdings has increased its EBIT by 9.7% over twelve months, which should ease any concerns about debt repayment. 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 Gas Industry Investment Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, China Gas Industry Investment Holdings created free cash flow amounting to 8.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

China Gas Industry Investment Holdings's net debt to EBITDA was a real positive on this analysis, as was its interest cover. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about China Gas Industry Investment Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. We've identified 2 warning signs with China Gas Industry Investment Holdings , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.