C&D International Investment Group (HKG:1908) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that C&D International Investment Group Limited (HKG:1908) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for C&D International Investment Group

What Is C&D International Investment Group's Net Debt?

As you can see below, at the end of June 2021, C&D International Investment Group had CN¥77.0b of debt, up from CN¥54.2b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥34.3b, its net debt is less, at about CN¥42.7b.

A Look At C&D International Investment Group's Liabilities

We can see from the most recent balance sheet that C&D International Investment Group had liabilities of CN¥167.2b falling due within a year, and liabilities of CN¥67.2b due beyond that. Offsetting these obligations, it had cash of CN¥34.3b as well as receivables valued at CN¥29.0b due within 12 months. So it has liabilities totalling CN¥171.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥16.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, C&D International Investment Group would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

As it happens C&D International Investment Group has a fairly concerning net debt to EBITDA ratio of 8.0 but very strong interest coverage of 13.1. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, C&D International Investment Group grew its EBIT by 69% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if C&D International Investment Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, C&D International Investment Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both C&D International Investment Group's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider C&D International Investment Group to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for C&D International Investment Group (1 is a bit unpleasant!) that you should be aware of before investing here.

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. 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.