Does China Tobacco International (HK) (HKG:6055) 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.' 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 Tobacco International (HK) Company Limited (HKG:6055) does carry 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. If things get really bad, the lenders can take control of the business. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for China Tobacco International (HK)

What Is China Tobacco International (HK)'s Debt?

The image below, which you can click on for greater detail, shows that at June 2023 China Tobacco International (HK) had debt of HK$2.30b, up from HK$2.08b in one year. However, it does have HK$2.16b in cash offsetting this, leading to net debt of about HK$140.5m.

How Healthy Is China Tobacco International (HK)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Tobacco International (HK) had liabilities of HK$3.63b due within 12 months and liabilities of HK$7.28m due beyond that. On the other hand, it had cash of HK$2.16b and HK$1.11b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$363.3m.

Of course, China Tobacco International (HK) has a market capitalization of HK$7.17b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

China Tobacco International (HK)'s net debt is only 0.14 times its EBITDA. And its EBIT covers its interest expense a whopping 16.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, China Tobacco International (HK) grew its EBIT by 72% over the last twelve months, and that growth will make it easier to handle its debt. 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 Tobacco International (HK)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Tobacco International (HK) recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

The good news is that China Tobacco International (HK)'s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that China Tobacco International (HK) takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you're interested in China Tobacco International (HK), you may well want to click here to check an interactive graph of its earnings per share history.

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.