The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that Chuang's Consortium International Limited (HKG:367) does use debt in its business. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is Chuang's Consortium International's Net Debt?
The chart below, which you can click on for greater detail, shows that Chuang's Consortium International had HK$6.88b in debt in September 2021; about the same as the year before. However, it does have HK$6.66b in cash offsetting this, leading to net debt of about HK$229.4m.
A Look At Chuang's Consortium International's Liabilities
Zooming in on the latest balance sheet data, we can see that Chuang's Consortium International had liabilities of HK$6.27b due within 12 months and liabilities of HK$1.68b due beyond that. Offsetting these obligations, it had cash of HK$6.66b as well as receivables valued at HK$256.5m due within 12 months. So it has liabilities totalling HK$1.04b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of HK$1.54b, so it does suggest shareholders should keep an eye on Chuang's Consortium International's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Even though Chuang's Consortium International's debt is only 1.8, its interest cover is really very low at 0.77. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. Shareholders should be aware that Chuang's Consortium International's EBIT was down 82% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Chuang's Consortium International'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Chuang's Consortium International burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Chuang's Consortium International's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Taking into account all the aforementioned factors, it looks like Chuang's Consortium International has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Chuang's Consortium International (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
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.