We Think China Hanking Holdings (HKG:3788) Can Stay On Top Of Its Debt

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. Importantly, China Hanking Holdings Limited (HKG:3788) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Hanking Holdings

How Much Debt Does China Hanking Holdings Carry?

As you can see below, at the end of December 2023, China Hanking Holdings had CN¥786.4m of debt, up from CN¥661.8m a year ago. Click the image for more detail. However, it does have CN¥273.1m in cash offsetting this, leading to net debt of about CN¥513.3m.

How Healthy Is China Hanking Holdings' Balance Sheet?

The latest balance sheet data shows that China Hanking Holdings had liabilities of CN¥2.05b due within a year, and liabilities of CN¥109.5m falling due after that. On the other hand, it had cash of CN¥273.1m and CN¥546.5m worth of receivables due within a year. So its liabilities total CN¥1.34b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥1.69b, 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.

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). 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).

Looking at its net debt to EBITDA of 1.2 and interest cover of 6.3 times, it seems to us that China Hanking Holdings is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Better yet, China Hanking Holdings grew its EBIT by 448% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Hanking Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. During the last three years, China Hanking Holdings generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, China Hanking Holdings's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like China Hanking Holdings is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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 2 warning signs we've spotted with China Hanking Holdings (including 1 which shouldn't be ignored) .

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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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.