Zhong Ao Home Group (HKG:1538) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Zhong Ao Home Group Limited (HKG:1538) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Zhong Ao Home Group

What Is Zhong Ao Home Group's Debt?

As you can see below, Zhong Ao Home Group had CN¥49.0m of debt at June 2023, down from CN¥68.3m a year prior. However, its balance sheet shows it holds CN¥398.0m in cash, so it actually has CN¥349.0m net cash.

How Strong Is Zhong Ao Home Group's Balance Sheet?

We can see from the most recent balance sheet that Zhong Ao Home Group had liabilities of CN¥930.7m falling due within a year, and liabilities of CN¥28.2m due beyond that. On the other hand, it had cash of CN¥398.0m and CN¥714.6m worth of receivables due within a year. So it actually has CN¥153.7m more liquid assets than total liabilities.

This surplus strongly suggests that Zhong Ao Home Group has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Succinctly put, Zhong Ao Home Group boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Zhong Ao Home Group's load is not too heavy, because its EBIT was down 26% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zhong Ao Home Group'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, a company can only pay off debt with cold hard cash, not accounting profits. While Zhong Ao Home Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Zhong Ao Home Group's free cash flow amounted to 46% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Zhong Ao Home Group has net cash of CN¥349.0m, as well as more liquid assets than liabilities. So we are not troubled with Zhong Ao Home Group's debt use. 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. To that end, you should learn about the 4 warning signs we've spotted with Zhong Ao Home Group (including 1 which is a bit concerning) .

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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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.