We Think Zhongsheng Group Holdings (HKG:881) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Zhongsheng Group Holdings Limited (HKG:881) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Zhongsheng Group Holdings

How Much Debt Does Zhongsheng Group Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Zhongsheng Group Holdings had CN¥29.9b of debt, an increase on CN¥22.4b, over one year. On the flip side, it has CN¥16.7b in cash leading to net debt of about CN¥13.3b.

How Healthy Is Zhongsheng Group Holdings' Balance Sheet?

The latest balance sheet data shows that Zhongsheng Group Holdings had liabilities of CN¥35.7b due within a year, and liabilities of CN¥19.3b falling due after that. Offsetting this, it had CN¥16.7b in cash and CN¥2.55b in receivables that were due within 12 months. So it has liabilities totalling CN¥35.8b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥48.7b, so it does suggest shareholders should keep an eye on Zhongsheng Group Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).

With net debt sitting at just 1.2 times EBITDA, Zhongsheng Group Holdings is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.0 times the interest expense over the last year. It is just as well that Zhongsheng Group Holdings's load is not too heavy, because its EBIT was down 24% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhongsheng Group Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Zhongsheng Group Holdings's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Zhongsheng Group Holdings's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Zhongsheng 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. 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. Be aware that Zhongsheng Group Holdings is showing 1 warning sign in our investment analysis , you should know about...

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.