Is China Beidahuang Industry Group Holdings (HKG:39) Using Too Much 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.' 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. Importantly, China Beidahuang Industry Group Holdings Limited (HKG:39) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Beidahuang Industry Group Holdings

What Is China Beidahuang Industry Group Holdings's Debt?

As you can see below, China Beidahuang Industry Group Holdings had HK$454.9m of debt at June 2023, down from HK$517.7m a year prior. However, it also had HK$141.7m in cash, and so its net debt is HK$313.2m.

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

The latest balance sheet data shows that China Beidahuang Industry Group Holdings had liabilities of HK$1.10b due within a year, and liabilities of HK$115.0m falling due after that. On the other hand, it had cash of HK$141.7m and HK$316.7m worth of receivables due within a year. So it has liabilities totalling HK$755.5m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of HK$740.9m, we think shareholders really should watch China Beidahuang Industry Group Holdings's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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

Weak interest cover of 0.18 times and a disturbingly high net debt to EBITDA ratio of 8.3 hit our confidence in China Beidahuang Industry Group Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for China Beidahuang Industry Group Holdings is that it turned last year's EBIT loss into a gain of HK$25m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. 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, 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. Happily for any shareholders, China Beidahuang Industry Group Holdings actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both China Beidahuang Industry Group Holdings's net debt to EBITDA and its track record of covering its interest expense with its EBIT 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. Once we consider all the factors above, together, it seems to us that China Beidahuang Industry Group Holdings's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for China Beidahuang Industry Group Holdings you should be aware of, and 2 of them are a bit concerning.

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.

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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.