China Resources Gas Group (HKG:1193) Has A Somewhat Strained Balance Sheet

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies China Resources Gas Group Limited (HKG:1193) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for China Resources Gas Group

What Is China Resources Gas Group's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2023 China Resources Gas Group had debt of HK$35.4b, up from HK$17.0b in one year. However, it also had HK$18.8b in cash, and so its net debt is HK$16.6b.

How Strong Is China Resources Gas Group's Balance Sheet?

The latest balance sheet data shows that China Resources Gas Group had liabilities of HK$52.0b due within a year, and liabilities of HK$26.0b falling due after that. On the other hand, it had cash of HK$18.8b and HK$18.9b worth of receivables due within a year. So it has liabilities totalling HK$40.3b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$52.5b, so it does suggest shareholders should keep an eye on China Resources Gas Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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 Resources Gas Group's net debt is only 1.5 times its EBITDA. And its EBIT easily covers its interest expense, being 15.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, China Resources Gas Group's EBIT dived 13%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Resources Gas Group 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.

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. In the last three years, China Resources Gas Group's free cash flow amounted to 20% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither China Resources Gas Group's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. It's also worth noting that China Resources Gas Group is in the Gas Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think China Resources Gas Group's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 1 warning sign for China Resources Gas Group that you should be aware of before investing here.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.