Here's Why CPMC Holdings (HKG:906) Is Weighed Down By Its Debt Load

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies CPMC Holdings Limited (HKG:906) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for CPMC Holdings

How Much Debt Does CPMC Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 CPMC Holdings had CN¥4.56b of debt, an increase on CN¥4.20b, over one year. On the flip side, it has CN¥1.17b in cash leading to net debt of about CN¥3.39b.

How Healthy Is CPMC Holdings's Balance Sheet?

We can see from the most recent balance sheet that CPMC Holdings had liabilities of CN¥3.87b falling due within a year, and liabilities of CN¥3.18b due beyond that. On the other hand, it had cash of CN¥1.17b and CN¥2.27b worth of receivables due within a year. So it has liabilities totalling CN¥3.60b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥3.12b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

CPMC Holdings has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 4.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably, CPMC Holdings's EBIT was pretty flat over the last year, which isn't ideal given the debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine CPMC Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, CPMC Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

We'd go so far as to say CPMC Holdings's conversion of EBIT to free cash flow was disappointing. But at least its EBIT growth rate is not so bad. Overall, it seems to us that CPMC Holdings's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with CPMC Holdings (at least 1 which is significant) , and understanding them should be part of your investment process.

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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