Is Zhongchang International Holdings Group (HKG:859) A Risky Investment?

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 note that Zhongchang International Holdings Group Limited (HKG:859) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Zhongchang International Holdings Group

How Much Debt Does Zhongchang International Holdings Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Zhongchang International Holdings Group had HK$870.9m of debt, an increase on HK$790.5m, over one year. However, it also had HK$123.0m in cash, and so its net debt is HK$747.8m.

A Look At Zhongchang International Holdings Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhongchang International Holdings Group had liabilities of HK$886.6m due within 12 months and liabilities of HK$18.5m due beyond that. Offsetting these obligations, it had cash of HK$123.0m as well as receivables valued at HK$2.97m due within 12 months. So it has liabilities totalling HK$779.1m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$180.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Zhongchang International Holdings Group 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zhongchang International Holdings Group shareholders face the double whammy of a high net debt to EBITDA ratio (29.8), and fairly weak interest coverage, since EBIT is just 0.57 times the interest expense. The debt burden here is substantial. On a lighter note, we note that Zhongchang International Holdings Group grew its EBIT by 24% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. There's no doubt that we learn most about debt from the balance sheet. But it is Zhongchang International Holdings 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Zhongchang International Holdings Group actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Zhongchang International Holdings Group's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Zhongchang International Holdings Group stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. We've identified 4 warning signs with Zhongchang International Holdings Group (at least 1 which is concerning) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.