Sino Gas Holdings Group (HKG:1759) Use Of Debt Could Be Considered Risky

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.' 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 Sino Gas Holdings Group Limited (HKG:1759) does use debt in its business. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Sino Gas Holdings Group

What Is Sino Gas Holdings Group's Debt?

As you can see below, at the end of June 2021, Sino Gas Holdings Group had CN¥555.6m of debt, up from CN¥140.9m a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥76.4m, its net debt is less, at about CN¥479.2m.

How Strong Is Sino Gas Holdings Group's Balance Sheet?

According to the last reported balance sheet, Sino Gas Holdings Group had liabilities of CN¥614.9m due within 12 months, and liabilities of CN¥32.5m due beyond 12 months. On the other hand, it had cash of CN¥76.4m and CN¥172.9m worth of receivables due within a year. So it has liabilities totalling CN¥398.2m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥447.1m, so it does suggest shareholders should keep an eye on Sino Gas Holdings Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Sino Gas Holdings Group has a fairly concerning net debt to EBITDA ratio of 14.4 but very strong interest coverage of 10.3. So either it has access to very cheap long term debt or that interest expense is going to grow! Shareholders should be aware that Sino Gas Holdings Group's EBIT was down 47% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Sino Gas Holdings Group'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sino Gas Holdings Group 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

To be frank both Sino Gas Holdings Group'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. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Sino Gas Holdings Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 6 warning signs for Sino Gas Holdings Group (2 are a bit concerning!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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