Creative China Holdings (HKG:8368) Has A Somewhat Strained Balance Sheet

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. We can see that Creative China Holdings Limited (HKG:8368) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Creative China Holdings

What Is Creative China Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Creative China Holdings had CN¥22.2m of debt, an increase on CN¥21.1m, over one year. However, it does have CN¥2.34m in cash offsetting this, leading to net debt of about CN¥19.8m.

How Strong Is Creative China Holdings' Balance Sheet?

We can see from the most recent balance sheet that Creative China Holdings had liabilities of CN¥99.9m falling due within a year, and liabilities of CN¥49.4m due beyond that. On the other hand, it had cash of CN¥2.34m and CN¥16.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥130.8m.

This deficit is considerable relative to its market capitalization of CN¥168.5m, so it does suggest shareholders should keep an eye on Creative China Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Looking at its net debt to EBITDA of 0.83 and interest cover of 4.4 times, it seems to us that Creative China Holdings is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that Creative China Holdings improved its EBIT from a last year's loss to a positive CN¥23m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Creative China Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Creative China Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Creative China Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Creative China Holdings's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Creative China Holdings (1 doesn't sit too well with us) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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