Does Hong Kong and China Gas (HKG:3) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 The Hong Kong and China Gas Company Limited (HKG:3) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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.

See our latest analysis for Hong Kong and China Gas

How Much Debt Does Hong Kong and China Gas Carry?

The image below, which you can click on for greater detail, shows that at June 2022 Hong Kong and China Gas had debt of HK$58.3b, up from HK$51.9b in one year. However, it also had HK$10.2b in cash, and so its net debt is HK$48.1b.

A Look At Hong Kong and China Gas' Liabilities

We can see from the most recent balance sheet that Hong Kong and China Gas had liabilities of HK$35.1b falling due within a year, and liabilities of HK$51.7b due beyond that. Offsetting this, it had HK$10.2b in cash and HK$8.79b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$67.8b.

While this might seem like a lot, it is not so bad since Hong Kong and China Gas has a huge market capitalization of HK$135.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

Hong Kong and China Gas's debt is 4.1 times its EBITDA, and its EBIT cover its interest expense 6.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Hong Kong and China Gas saw its EBIT slide 5.9% in the last twelve months. 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 Hong Kong and China Gas 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Hong Kong and China Gas recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Hong Kong and China Gas's EBIT growth rate makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. At least its interest cover gives us reason to be optimistic. It's also worth noting that Hong Kong and China Gas is in the Gas Utilities industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that Hong Kong and China Gas is taking some risks with its use of debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Hong Kong and China Gas (2 are significant) 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. 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.