Zhongsheng Group Holdings (HKG:881) Has A Somewhat Strained Balance Sheet

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. Importantly, Zhongsheng Group Holdings Limited (HKG:881) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See 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 December 2022 Zhongsheng Group Holdings had CN¥26.3b of debt, an increase on CN¥24.1b, over one year. On the flip side, it has CN¥11.9b in cash leading to net debt of about CN¥14.3b.

A Look At Zhongsheng Group Holdings' Liabilities

We can see from the most recent balance sheet that Zhongsheng Group Holdings had liabilities of CN¥28.9b falling due within a year, and liabilities of CN¥18.7b due beyond that. Offsetting these obligations, it had cash of CN¥11.9b as well as receivables valued at CN¥1.80b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥33.8b.

While this might seem like a lot, it is not so bad since Zhongsheng Group Holdings has a huge market capitalization of CN¥69.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Zhongsheng Group Holdings has a low net debt to EBITDA ratio of only 1.2. And its EBIT covers its interest expense a whopping 10.0 times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Zhongsheng Group Holdings if management cannot prevent a repeat of the 21% cut to EBIT 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 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by 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's not great, when it comes to paying down debt.

Our View

Zhongsheng Group Holdings's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. When we consider all the factors discussed, it seems to us that Zhongsheng Group Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Zhongsheng Group Holdings you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.