Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. 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 Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
How Much Debt Does Zhong Ao Home Group Carry?
The image below, which you can click on for greater detail, shows that Zhong Ao Home Group had debt of CN¥91.3m at the end of June 2021, a reduction from CN¥182.1m over a year. But on the other hand it also has CN¥392.6m in cash, leading to a CN¥301.3m net cash position.
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¥1.47b due within 12 months, and liabilities of CN¥29.5m due beyond 12 months. On the other hand, it had cash of CN¥392.6m and CN¥899.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥211.1m.
While this might seem like a lot, it is not so bad since Zhong Ao Home Group has a market capitalization of CN¥434.3m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. 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.
But the other side of the story is that Zhong Ao Home Group saw its EBIT decline by 2.5% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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. During the last three years, Zhong Ao Home Group produced sturdy free cash flow equating to 80% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Although Zhong Ao Home Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥301.3m. The cherry on top was that in converted 80% of that EBIT to free cash flow, bringing in CN¥172m. 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. Be aware that Zhong Ao Home Group is showing 2 warning signs in our investment analysis , you should know about...
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.
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.
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