These 4 Measures Indicate That Zhuguang Holdings Group (HKG:1176) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Zhuguang Holdings Group Company Limited (HKG:1176) does carry debt. But should shareholders be worried about its use of debt?

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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Zhuguang Holdings Group

What Is Zhuguang Holdings Group's Debt?

The image below, which you can click on for greater detail, shows that Zhuguang Holdings Group had debt of HK$17.0b at the end of December 2020, a reduction from HK$18.2b over a year. However, it also had HK$3.53b in cash, and so its net debt is HK$13.5b.

How Strong Is Zhuguang Holdings Group's Balance Sheet?

According to the last reported balance sheet, Zhuguang Holdings Group had liabilities of HK$16.8b due within 12 months, and liabilities of HK$10.7b due beyond 12 months. Offsetting these obligations, it had cash of HK$3.53b as well as receivables valued at HK$6.23b due within 12 months. So its liabilities total HK$17.7b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of HK$15.9b, we think shareholders really should watch Zhuguang Holdings Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Zhuguang Holdings Group's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 2.6 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, it should be some comfort for shareholders to recall that Zhuguang Holdings Group actually grew its EBIT by a hefty 150%, 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zhuguang 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zhuguang Holdings Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Zhuguang Holdings Group's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Zhuguang Holdings Group'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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zhuguang Holdings Group is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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.
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