Is China Tian Lun Gas Holdings (HKG:1600) A Risky Investment?

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.' 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. Importantly, China Tian Lun Gas Holdings Limited (HKG:1600) does carry 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View 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¥5.14b in debt in June 2020; about the same as the year before. However, it also had CN¥1.31b in cash, and so its net debt is CN¥3.83b.

How Strong Is China Tian Lun Gas Holdings's Balance Sheet?

We can see from the most recent balance sheet that China Tian Lun Gas Holdings had liabilities of CN¥4.14b falling due within a year, and liabilities of CN¥3.93b due beyond that. On the other hand, it had cash of CN¥1.31b and CN¥2.04b worth of receivables due within a year. So its liabilities total CN¥4.71b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥5.53b, so it does suggest shareholders should keep an eye on China Tian Lun Gas Holdings's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Tian Lun Gas Holdings's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 5.3 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Sadly, China Tian Lun Gas Holdings's EBIT actually dropped 4.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Tian Lun Gas Holdings 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, China Tian Lun Gas Holdings recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On this analysis China Tian Lun Gas Holdings's level of total liabilities and EBIT growth rate both make us a little nervous. But at least its interest cover is not so bad. 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 the balance sheet and taking into account all these factors, we do believe that debt is making China Tian Lun Gas Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 2 warning signs for China Tian Lun Gas Holdings you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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