China Tian Lun Gas Holdings (HKG:1600) Has A Somewhat Strained Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies China Tian Lun Gas Holdings Limited (HKG:1600) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for China Tian Lun Gas Holdings

What Is China Tian Lun Gas Holdings's Debt?

The chart below, which you can click on for greater detail, shows that China Tian Lun Gas Holdings had CN¥5.06b in debt in December 2020; about the same as the year before. However, it does have CN¥1.67b in cash offsetting this, leading to net debt of about CN¥3.40b.

How Healthy Is China Tian Lun Gas Holdings' Balance Sheet?

According to the last reported balance sheet, China Tian Lun Gas Holdings had liabilities of CN¥4.56b due within 12 months, and liabilities of CN¥3.38b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.67b as well as receivables valued at CN¥1.91b due within 12 months. So its liabilities total CN¥4.36b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥6.74b, so it does suggest shareholders should keep an eye on China Tian Lun Gas Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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 Tian Lun Gas Holdings has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. China Tian Lun Gas Holdings grew its EBIT by 5.5% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Tian Lun Gas Holdings'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.

Finally, while the tax-man may adore accounting profits, lenders only accept 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 Tian Lun Gas Holdings created free cash flow amounting to 19% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both China Tian Lun Gas Holdings's conversion of EBIT to free cash flow and its level of total liabilities were discouraging. At least its interest cover gives us reason to be optimistic. It's also worth noting that China Tian Lun Gas Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that China Tian Lun Gas Holdings is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 2 warning signs for China Tian Lun Gas Holdings that you should be aware of before investing here.

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. 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.
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