Here's Why HongGuang Lighting Holdings (HKG:6908) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that HongGuang Lighting Holdings Company Limited (HKG:6908) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for HongGuang Lighting Holdings

What Is HongGuang Lighting Holdings's Debt?

As you can see below, HongGuang Lighting Holdings had CN¥13.0m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of CN¥11.4m, its net debt is less, at about CN¥1.60m.

How Strong Is HongGuang Lighting Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that HongGuang Lighting Holdings had liabilities of CN¥47.3m due within 12 months and liabilities of CN¥1.13m due beyond that. Offsetting this, it had CN¥11.4m in cash and CN¥114.5m in receivables that were due within 12 months. So it actually has CN¥77.5m more liquid assets than total liabilities.

This short term liquidity is a sign that HongGuang Lighting Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched. Carrying virtually no net debt, HongGuang Lighting Holdings has a very light debt load indeed.

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). 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).

HongGuang Lighting Holdings has net debt of just 0.16 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.9 times the interest expense over the last year. In fact HongGuang Lighting Holdings's saving grace is its low debt levels, because its EBIT has tanked 79% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since HongGuang Lighting Holdings will need earnings to service that debt. 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, 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. Looking at the most recent three years, HongGuang Lighting Holdings recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Based on what we've seen HongGuang Lighting Holdings is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to handle its debt, based on its EBITDA, is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about HongGuang Lighting Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with HongGuang Lighting Holdings , and understanding them should be part of your investment process.

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. 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.
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