Here's Why Greentown China Holdings (HKG:3900) Has A Meaningful Debt Burden

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 Greentown China Holdings Limited (HKG:3900) makes use of 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. 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. 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.

See our latest analysis for Greentown China Holdings

What Is Greentown China Holdings's Net Debt?

As you can see below, Greentown China Holdings had CN¥142.6b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥65.4b in cash leading to net debt of about CN¥77.3b.

How Strong Is Greentown China Holdings' Balance Sheet?

We can see from the most recent balance sheet that Greentown China Holdings had liabilities of CN¥322.5b falling due within a year, and liabilities of CN¥116.1b due beyond that. Offsetting this, it had CN¥65.4b in cash and CN¥90.9b in receivables that were due within 12 months. So it has liabilities totalling CN¥282.4b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥16.8b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Greentown China Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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

As it happens Greentown China Holdings has a fairly concerning net debt to EBITDA ratio of 5.8 but very strong interest coverage of 28.8. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably Greentown China Holdings's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Greentown China 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Greentown China Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

While Greentown China Holdings's level of total liabilities has us nervous. For example, its interest cover and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Greentown China Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 2 warning signs for Greentown China Holdings that 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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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.