Does China ZhengTong Auto Services Holdings (HKG:1728) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies China ZhengTong Auto Services Holdings Limited (HKG:1728) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for China ZhengTong Auto Services Holdings

What Is China ZhengTong Auto Services Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that China ZhengTong Auto Services Holdings had CN¥17.8b of debt in June 2020, down from CN¥22.3b, one year before. However, it also had CN¥2.31b in cash, and so its net debt is CN¥15.5b.

How Strong Is China ZhengTong Auto Services Holdings's Balance Sheet?

We can see from the most recent balance sheet that China ZhengTong Auto Services Holdings had liabilities of CN¥22.8b falling due within a year, and liabilities of CN¥6.19b due beyond that. Offsetting these obligations, it had cash of CN¥2.31b as well as receivables valued at CN¥14.6b due within 12 months. So it has liabilities totalling CN¥12.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥2.47b 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, China ZhengTong Auto Services Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 8.1 hit our confidence in China ZhengTong Auto Services Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, China ZhengTong Auto Services Holdings saw its EBIT tank 44% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, China ZhengTong Auto Services Holdings burned a lot of cash. 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

On the face of it, China ZhengTong Auto Services Holdings's EBIT growth rate 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. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that China ZhengTong Auto Services Holdings is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with China ZhengTong Auto Services Holdings (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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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