Does Hongkong Chinese (HKG:655) Have A Healthy Balance Sheet?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Hongkong Chinese Limited (HKG:655) makes use of debt. But should shareholders be worried about its use of debt?

We've discovered 2 warning signs about Hongkong Chinese. View them for free.

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Hongkong Chinese's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2024 Hongkong Chinese had HK$501.5m of debt, an increase on HK$465.7m, over one year. However, it also had HK$97.4m in cash, and so its net debt is HK$404.1m.

How Healthy Is Hongkong Chinese's Balance Sheet?

The latest balance sheet data shows that Hongkong Chinese had liabilities of HK$50.9m due within a year, and liabilities of HK$512.4m falling due after that. Offsetting this, it had HK$97.4m in cash and HK$3.03m in receivables that were due within 12 months. So its liabilities total HK$462.9m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$509.6m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

Check out our latest analysis for Hongkong Chinese

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 9.9 hit our confidence in Hongkong Chinese like a one-two punch to the gut. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Hongkong Chinese actually grew its EBIT by a hefty 112%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. There's no doubt that we learn most about debt from the balance sheet. But it is Hongkong Chinese'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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Hongkong Chinese saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Hongkong Chinese's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Hongkong Chinese's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Be aware that Hongkong Chinese is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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.