China ZhengTong Auto Services Holdings (HKG:1728) Has No Shortage Of 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. Importantly, China ZhengTong Auto Services Holdings Limited (HKG:1728) does carry debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

See our latest analysis for China ZhengTong Auto Services Holdings

What Is China ZhengTong Auto Services Holdings's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 China ZhengTong Auto Services Holdings had debt of CN¥18.7b, up from CN¥14.5b in one year. On the flip side, it has CN¥1.63b in cash leading to net debt of about CN¥17.1b.

How Healthy Is China ZhengTong Auto Services Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China ZhengTong Auto Services Holdings had liabilities of CN¥22.9b due within 12 months and liabilities of CN¥3.55b due beyond that. On the other hand, it had cash of CN¥1.63b and CN¥4.29b worth of receivables due within a year. So its liabilities total CN¥20.5b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥1.03b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China ZhengTong Auto Services Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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 0.09 times and a disturbingly high net debt to EBITDA ratio of 27.2 hit our confidence in China ZhengTong Auto Services Holdings like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that China ZhengTong Auto Services Holdings achieved a positive EBIT of CN¥106m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China ZhengTong Auto Services Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, China ZhengTong Auto Services Holdings 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

On the face of it, China ZhengTong Auto Services Holdings's conversion of EBIT to free cash flow 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. Having said that, its ability to grow its EBIT isn't such a worry. We think the chances that China ZhengTong Auto Services Holdings has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Even though China ZhengTong Auto Services Holdings lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.