Is Zhong Ao Home Group (HKG:1538) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Zhong Ao Home Group Limited (HKG:1538) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Ao Home Group

How Much Debt Does Zhong Ao Home Group Carry?

You can click the graphic below for the historical numbers, but it shows that Zhong Ao Home Group had CN¥79.3m of debt in December 2020, down from CN¥130.5m, one year before. But on the other hand it also has CN¥510.8m in cash, leading to a CN¥431.5m net cash position.

A Look At Zhong Ao Home Group's Liabilities

The latest balance sheet data shows that Zhong Ao Home Group had liabilities of CN¥1.10b due within a year, and liabilities of CN¥76.9m falling due after that. Offsetting these obligations, it had cash of CN¥510.8m as well as receivables valued at CN¥374.2m due within 12 months. So it has liabilities totalling CN¥293.1m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Zhong Ao Home Group has a market capitalization of CN¥635.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Zhong Ao Home Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, Zhong Ao Home Group saw its EBIT drop by 4.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zhong Ao Home 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 company can only pay off debt with cold hard cash, not accounting profits. 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 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While Zhong Ao Home Group does have more liabilities than liquid assets, it also has net cash of CN¥431.5m. The cherry on top was that in converted 78% of that EBIT to free cash flow, bringing in CN¥163m. So we are not troubled with Zhong Ao Home Group's debt use. 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. For example, we've discovered 3 warning signs for Zhong Ao Home Group that you should be aware of before investing here.

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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