Is Zhong Ao Home Group (HKG:1538) A Risky Investment?

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.' 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. Importantly, Zhong Ao Home Group Limited (HKG:1538) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Zhong Ao Home Group

What Is Zhong Ao Home Group's Net Debt?

The image below, which you can click on for greater detail, shows that Zhong Ao Home Group had debt of CN¥68.3m at the end of June 2022, a reduction from CN¥91.3m over a year. However, it does have CN¥417.0m in cash offsetting this, leading to net cash of CN¥348.7m.

How Strong Is Zhong Ao Home Group's Balance Sheet?

According to the last reported balance sheet, Zhong Ao Home Group had liabilities of CN¥993.5m due within 12 months, and liabilities of CN¥29.3m due beyond 12 months. Offsetting these obligations, it had cash of CN¥417.0m as well as receivables valued at CN¥685.6m due within 12 months. So it actually has CN¥79.8m more liquid assets than total liabilities.

This surplus liquidity suggests that Zhong Ao Home Group's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Zhong Ao Home Group boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Zhong Ao Home Group has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zhong Ao Home Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Zhong Ao Home Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Zhong Ao Home Group recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Zhong Ao Home Group has net cash of CN¥348.7m, as well as more liquid assets than liabilities. So we don't have any problem with Zhong Ao Home Group's use of debt. 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. Case in point: We've spotted 2 warning signs for Zhong Ao Home Group you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.