Does China ITS (Holdings) (HKG:1900) Have A Healthy 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.' 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. Importantly, China ITS (Holdings) Co., Ltd. (HKG:1900) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China ITS (Holdings)

How Much Debt Does China ITS (Holdings) Carry?

As you can see below, China ITS (Holdings) had CN¥596.5m of debt at December 2020, down from CN¥981.1m a year prior. On the flip side, it has CN¥240.6m in cash leading to net debt of about CN¥355.8m.

How Strong Is China ITS (Holdings)'s Balance Sheet?

The latest balance sheet data shows that China ITS (Holdings) had liabilities of CN¥1.59b due within a year, and liabilities of CN¥49.1m falling due after that. Offsetting this, it had CN¥240.6m in cash and CN¥1.21b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥189.6m.

This is a mountain of leverage relative to its market capitalization of CN¥297.5m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

China ITS (Holdings) shareholders face the double whammy of a high net debt to EBITDA ratio (6.7), and fairly weak interest coverage, since EBIT is just 1.1 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, China ITS (Holdings) saw its EBIT tank 24% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 China ITS (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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last two years, China ITS (Holdings) created free cash flow amounting to 7.3% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both China ITS (Holdings)'s interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like China ITS (Holdings) has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. 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 2 warning signs for China ITS (Holdings) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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