China Beidahuang Industry Group Holdings (HKG:39) Use Of Debt Could Be Considered Risky

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. We note that China Beidahuang Industry Group Holdings Limited (HKG:39) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Beidahuang Industry Group Holdings

What Is China Beidahuang Industry Group Holdings's Net Debt?

As you can see below, at the end of December 2021, China Beidahuang Industry Group Holdings had HK$535.9m of debt, up from HK$504.9m a year ago. Click the image for more detail. However, it also had HK$178.4m in cash, and so its net debt is HK$357.5m.

How Strong Is China Beidahuang Industry Group Holdings' Balance Sheet?

According to the last reported balance sheet, China Beidahuang Industry Group Holdings had liabilities of HK$1.19b due within 12 months, and liabilities of HK$588.1m due beyond 12 months. Offsetting these obligations, it had cash of HK$178.4m as well as receivables valued at HK$426.9m due within 12 months. So it has liabilities totalling HK$1.17b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$354.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, China Beidahuang Industry Group 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). 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).

China Beidahuang Industry Group Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (6.9), and fairly weak interest coverage, since EBIT is just 0.30 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, China Beidahuang Industry Group Holdings's EBIT was down 26% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Beidahuang Industry Group Holdings'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 that EBIT is backed by free cash flow. Over the last two years, China Beidahuang Industry Group Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both China Beidahuang Industry Group Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like China Beidahuang Industry Group Holdings has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for China Beidahuang Industry Group Holdings (1 can't be ignored!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.