Hong Kong and China Gas (HKG:3) Seems To Use Debt Quite Sensibly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that The Hong Kong and China Gas Company Limited (HKG:3) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. 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 Hong Kong and China Gas

What Is Hong Kong and China Gas's Debt?

As you can see below, at the end of June 2021, Hong Kong and China Gas had HK$51.9b of debt, up from HK$42.0b a year ago. Click the image for more detail. On the flip side, it has HK$8.48b in cash leading to net debt of about HK$43.4b.

How Strong Is Hong Kong and China Gas' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hong Kong and China Gas had liabilities of HK$36.8b due within 12 months and liabilities of HK$43.4b due beyond that. Offsetting this, it had HK$8.48b in cash and HK$7.35b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$64.3b.

Hong Kong and China Gas has a very large market capitalization of HK$218.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Hong Kong and China Gas has net debt to EBITDA of 3.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.4 times its interest expense, and its net debt to EBITDA, was quite high, at 3.6. If Hong Kong and China Gas can keep growing EBIT at last year's rate of 15% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hong Kong and China Gas's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Hong Kong and China Gas's free cash flow amounted to 34% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Hong Kong and China Gas's interest cover was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. We would also note that Gas Utilities industry companies like Hong Kong and China Gas commonly do use debt without problems. Considering this range of data points, we think Hong Kong and China Gas is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Hong Kong and China Gas has 1 warning sign we think you should be aware of.

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.