China Infrastructure & Logistics Group (HKG:1719) Takes On Some Risk With Its Use Of Debt

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 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. As with many other companies China Infrastructure & Logistics Group Ltd. (HKG:1719) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China Infrastructure & Logistics Group

What Is China Infrastructure & Logistics Group's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2020 China Infrastructure & Logistics Group had debt of HK$526.1m, up from HK$486.0m in one year. On the flip side, it has HK$74.0m in cash leading to net debt of about HK$452.1m.

How Healthy Is China Infrastructure & Logistics Group's Balance Sheet?

We can see from the most recent balance sheet that China Infrastructure & Logistics Group had liabilities of HK$577.3m falling due within a year, and liabilities of HK$334.8m due beyond that. Offsetting this, it had HK$74.0m in cash and HK$204.2m in receivables that were due within 12 months. So its liabilities total HK$633.9m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since China Infrastructure & Logistics Group has a market capitalization of HK$1.57b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 8.2 hit our confidence in China Infrastructure & Logistics Group like a one-two punch to the gut. The debt burden here is substantial. Even worse, China Infrastructure & Logistics Group saw its EBIT tank 35% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Infrastructure & Logistics Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, China Infrastructure & Logistics Group recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both China Infrastructure & Logistics Group's EBIT growth rate and its net debt to EBITDA were discouraging. But on the brighter side of life, its conversion of EBIT to free cash flow leaves us feeling more frolicsome. We should also note that Infrastructure industry companies like China Infrastructure & Logistics Group commonly do use debt without problems. When we consider all the factors discussed, it seems to us that China Infrastructure & Logistics Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 4 warning signs for China Infrastructure & Logistics Group you should be aware of, and 2 of them are potentially serious.

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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