We Think CIFI Holdings (Group) (HKG:884) Is Taking Some Risk With 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that CIFI Holdings (Group) Co. Ltd. (HKG:884) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for CIFI Holdings (Group)

What Is CIFI Holdings (Group)'s Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 CIFI Holdings (Group) had CN¥137.6b of debt, an increase on CN¥124.4b, over one year. However, because it has a cash reserve of CN¥57.5b, its net debt is less, at about CN¥80.0b.

A Look At CIFI Holdings (Group)'s Liabilities

The latest balance sheet data shows that CIFI Holdings (Group) had liabilities of CN¥247.6b due within a year, and liabilities of CN¥95.8b falling due after that. Offsetting this, it had CN¥57.5b in cash and CN¥118.3b in receivables that were due within 12 months. So it has liabilities totalling CN¥167.7b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥34.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, CIFI Holdings (Group) would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Strangely CIFI Holdings (Group) has a sky high EBITDA ratio of 7.0, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Also relevant is that CIFI Holdings (Group) has grown its EBIT by a very respectable 24% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if CIFI Holdings (Group) can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, CIFI Holdings (Group)'s free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, CIFI Holdings (Group)'s net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that CIFI Holdings (Group)'s debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for CIFI Holdings (Group) (of which 1 is concerning!) 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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