Here's Why Zhong Hua International Holdings (HKG:1064) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Zhong Hua International Holdings Limited (HKG:1064) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

Check out our latest analysis for Zhong Hua International Holdings

What Is Zhong Hua International Holdings's Net Debt?

The chart below, which you can click on for greater detail, shows that Zhong Hua International Holdings had HK$74.9m in debt in June 2022; about the same as the year before. However, it also had HK$66.3m in cash, and so its net debt is HK$8.55m.

How Healthy Is Zhong Hua International Holdings' Balance Sheet?

We can see from the most recent balance sheet that Zhong Hua International Holdings had liabilities of HK$135.2m falling due within a year, and liabilities of HK$1.29b due beyond that. On the other hand, it had cash of HK$66.3m and HK$26.2m worth of receivables due within a year. So its liabilities total HK$1.33b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$67.8m 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, Zhong Hua International Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

Zhong Hua International Holdings has a low net debt to EBITDA ratio of only 0.31. And its EBIT covers its interest expense a whopping 16.7 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Zhong Hua International Holdings grew its EBIT by 2,240% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zhong Hua International Holdings'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. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Zhong Hua International Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Zhong Hua International Holdings's level of total liabilities was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Zhong Hua International Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 example Zhong Hua International Holdings has 4 warning signs (and 3 which make us uncomfortable) we think you should know about.

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.