Is Air China (HKG:753) Using Debt In A Risky Way?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Air China Limited (HKG:753) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Air China

What Is Air China's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2021 Air China had CN¥79.3b of debt, an increase on CN¥68.8b, over one year. However, because it has a cash reserve of CN¥9.96b, its net debt is less, at about CN¥69.4b.

How Strong Is Air China's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Air China had liabilities of CN¥87.3b due within 12 months and liabilities of CN¥123.7b due beyond that. Offsetting these obligations, it had cash of CN¥9.96b as well as receivables valued at CN¥7.21b due within 12 months. So its liabilities total CN¥193.8b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥92.9b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Air China would probably need a major re-capitalization if its creditors were to demand repayment. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Air China can strengthen its balance sheet over time. 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 45%, to CN¥67b. To be frank that doesn't bode well.

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). Indeed, it lost a very considerable CN¥14b at the EBIT level. When we look at that alongside the significant liabilities, we're not particularly confident about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it had negative free cash flow of CN¥919m over the last twelve months. So suffice it to say we consider the stock to be risky. 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. Be aware that Air China is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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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