We Think Zhong Ao Home Group (HKG:1538) Can Stay On Top Of Its 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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Zhong Ao Home Group Limited (HKG:1538) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, 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 as of June 2020 Zhong Ao Home Group had CN¥182.1m of debt, an increase on CN¥167.6m, over one year. However, its balance sheet shows it holds CN¥457.9m in cash, so it actually has CN¥275.8m net cash.

A Look At Zhong Ao Home Group's Liabilities

According to the last reported balance sheet, Zhong Ao Home Group had liabilities of CN¥1.21b due within 12 months, and liabilities of CN¥108.4m due beyond 12 months. Offsetting these obligations, it had cash of CN¥457.9m as well as receivables valued at CN¥641.4m due within 12 months. So it has liabilities totalling CN¥219.4m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Zhong Ao Home Group is worth CN¥547.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Zhong Ao Home Group boasts net cash, so it's fair to say it does not have a heavy debt load!

In addition to that, we're happy to report that Zhong Ao Home Group has boosted its EBIT by 58%, thus reducing the spectre of future debt repayments. 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. During the last three years, Zhong Ao Home Group produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While Zhong Ao Home Group does have more liabilities than liquid assets, it also has net cash of CN¥275.8m. And we liked the look of last year's 58% year-on-year EBIT growth. So is Zhong Ao Home Group's debt a risk? It doesn't seem so to us. 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 4 warning signs in our investment analysis , you should know about...

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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