Stock Analysis

Health Check: How Prudently Does Air China (HKG:753) Use Debt?

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SEHK:753
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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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Air China Limited (HKG:753) makes use of debt. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Air China

What Is Air China's Net Debt?

As you can see below, at the end of September 2020, Air China had CN¥67.3b of debt, up from CN¥52.4b a year ago. Click the image for more detail. On the flip side, it has CN¥9.70b in cash leading to net debt of about CN¥57.6b.

debt-equity-history-analysis
SEHK:753 Debt to Equity History January 6th 2021

How Healthy Is Air China's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Air China had liabilities of CN¥87.5b due within 12 months and liabilities of CN¥115.6b due beyond that. Offsetting these obligations, it had cash of CN¥9.70b as well as receivables valued at CN¥8.47b due within 12 months. So it has liabilities totalling CN¥185.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥96.7b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Air China would probably need a major re-capitalization if its creditors were to demand repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Air China'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.

In the last year Air China had a loss before interest and tax, and actually shrunk its revenue by 40%, to CN¥82b. That makes us nervous, to say the least.

Caveat Emptor

Not only did Air China's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at CN¥7.3b. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through CN¥4.8b in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Air China , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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