Huajin International Holdings (HKG:2738) Seems To Use Debt Quite Sensibly

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.' 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, Huajin International Holdings Limited (HKG:2738) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Huajin International Holdings

What Is Huajin International Holdings's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Huajin International Holdings had debt of CN¥959.9m, up from CN¥790.8m in one year. On the flip side, it has CN¥46.2m in cash leading to net debt of about CN¥913.6m.

How Strong Is Huajin International Holdings' Balance Sheet?

The latest balance sheet data shows that Huajin International Holdings had liabilities of CN¥1.14b due within a year, and liabilities of CN¥335.8m falling due after that. Offsetting this, it had CN¥46.2m in cash and CN¥322.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.10b.

This deficit is considerable relative to its market capitalization of CN¥1.17b, so it does suggest shareholders should keep an eye on Huajin International Holdings' use of debt. 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). 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).

Huajin International Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (12.0), and fairly weak interest coverage, since EBIT is just 2.2 times the interest expense. The debt burden here is substantial. The good news is that Huajin International Holdings grew its EBIT a smooth 50% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 Huajin International 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Huajin International Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Huajin International Holdings's net debt to EBITDA was a real negative on this analysis, as was its interest cover. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Huajin International Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Huajin International Holdings (including 2 which make us uncomfortable) .

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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