These 4 Measures Indicate That China Resources Gas Group (HKG:1193) Is Using Debt Extensively

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.' 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. Importantly, China Resources Gas Group Limited (HKG:1193) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China Resources Gas Group

How Much Debt Does China Resources Gas Group Carry?

The image below, which you can click on for greater detail, shows that at December 2022 China Resources Gas Group had debt of HK$17.7b, up from HK$11.6b in one year. On the flip side, it has HK$6.44b in cash leading to net debt of about HK$11.3b.

A Look At China Resources Gas Group's Liabilities

According to the last reported balance sheet, China Resources Gas Group had liabilities of HK$46.2b due within 12 months, and liabilities of HK$13.3b due beyond 12 months. Offsetting these obligations, it had cash of HK$6.44b as well as receivables valued at HK$20.3b due within 12 months. So it has liabilities totalling HK$32.7b more than its cash and near-term receivables, combined.

China Resources Gas Group has a market capitalization of HK$67.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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 has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 25.3 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that China Resources Gas Group saw its EBIT decline by 9.2% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, China Resources Gas Group's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

China Resources Gas Group's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We should also note that Gas Utilities industry companies like China Resources Gas Group commonly do use debt without problems. We think that China Resources Gas Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with China Resources Gas Group , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.