Hongkong Chinese (HKG:655) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 can see that Hongkong Chinese Limited (HKG:655) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hongkong Chinese

What Is Hongkong Chinese's Net Debt?

As you can see below, at the end of September 2020, Hongkong Chinese had HK$519.2m of debt, up from HK$489.2m a year ago. Click the image for more detail. However, it does have HK$432.6m in cash offsetting this, leading to net debt of about HK$86.5m.

A Look At Hongkong Chinese's Liabilities

The latest balance sheet data shows that Hongkong Chinese had liabilities of HK$99.6m due within a year, and liabilities of HK$510.1m falling due after that. Offsetting these obligations, it had cash of HK$432.6m as well as receivables valued at HK$11.3m due within 12 months. So it has liabilities totalling HK$165.8m more than its cash and near-term receivables, combined.

Since publicly traded Hongkong Chinese shares are worth a total of HK$1.34b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

Weak interest cover of 0.41 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in Hongkong Chinese like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Hongkong Chinese is that it turned last year's EBIT loss into a gain of HK$6.7m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Hongkong Chinese's earnings that will influence how the balance sheet holds up in the future. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Hongkong Chinese saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Hongkong Chinese's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, we think it's fair to say that Hongkong Chinese has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Hongkong Chinese has 2 warning signs (and 1 which is a bit concerning) we think 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.

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This article by Simply Wall St is general in nature. 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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