China Hanking Holdings (HKG:3788) Seems To Use Debt Quite Sensibly

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.' 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. We note that China Hanking Holdings Limited (HKG:3788) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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.

See our latest analysis for China Hanking Holdings

How Much Debt Does China Hanking Holdings Carry?

As you can see below, at the end of December 2020, China Hanking Holdings had CN¥767.5m of debt, up from CN¥728.3m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥186.8m, its net debt is less, at about CN¥580.7m.

How Healthy Is China Hanking Holdings' Balance Sheet?

We can see from the most recent balance sheet that China Hanking Holdings had liabilities of CN¥1.74b falling due within a year, and liabilities of CN¥352.7m due beyond that. Offsetting these obligations, it had cash of CN¥186.8m as well as receivables valued at CN¥217.5m due within 12 months. So it has liabilities totalling CN¥1.69b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥2.27b, so it does suggest shareholders should keep an eye on China Hanking Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt sitting at just 0.75 times EBITDA, China Hanking Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.4 times the interest expense over the last year. On the other hand, China Hanking Holdings saw its EBIT drop by 2.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Hanking 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Hanking 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

When it comes to the balance sheet, the standout positive for China Hanking Holdings was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. Considering this range of data points, we think China Hanking Holdings is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - China Hanking Holdings has 4 warning signs we think you should be aware of.

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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