These 4 Measures Indicate That Zhongsheng Group Holdings (HKG:881) Is Using Debt Reasonably Well

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Zhongsheng Group Holdings Limited (HKG:881) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Zhongsheng Group Holdings

How Much Debt Does Zhongsheng Group Holdings Carry?

As you can see below, Zhongsheng Group Holdings had CN¥24.1b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥11.3b in cash offsetting this, leading to net debt of about CN¥12.7b.

How Healthy Is Zhongsheng Group Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zhongsheng Group Holdings had liabilities of CN¥28.4b due within 12 months and liabilities of CN¥16.4b due beyond that. Offsetting these obligations, it had cash of CN¥11.3b as well as receivables valued at CN¥1.84b due within 12 months. So its liabilities total CN¥31.6b more than the combination of its cash and short-term receivables.

Zhongsheng Group Holdings has a very large market capitalization of CN¥108.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zhongsheng Group Holdings has a low net debt to EBITDA ratio of only 0.92. And its EBIT covers its interest expense a whopping 13.3 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, Zhongsheng Group Holdings grew its EBIT by 41% 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 Zhongsheng Group 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Zhongsheng Group Holdings's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Zhongsheng Group Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Taking all this data into account, it seems to us that Zhongsheng Group Holdings takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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 instance, we've identified 1 warning sign for Zhongsheng Group Holdings that you should be aware of.

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.