Hong Kong and China Gas (HKG:3) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that The Hong Kong and China Gas Company Limited (HKG:3) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out 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 December 2021, Hong Kong and China Gas had HK$55.5b of debt, up from HK$43.4b a year ago. Click the image for more detail. However, it does have HK$10.6b in cash offsetting this, leading to net debt of about HK$44.8b.

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

According to the last reported balance sheet, Hong Kong and China Gas had liabilities of HK$38.5b due within 12 months, and liabilities of HK$47.7b due beyond 12 months. On the other hand, it had cash of HK$10.6b and HK$8.63b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$67.0b.

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$168.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hong Kong and China Gas has a debt to EBITDA ratio of 3.9 and its EBIT covered its interest expense 6.3 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Hong Kong and China Gas grew its EBIT by 5.0% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Hong Kong and China Gas's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Hong Kong and China Gas's net debt to EBITDA and its conversion of EBIT to free cash flow were discouraging. But its not so bad at covering its interest expense with its EBIT. We should also note that Gas Utilities industry companies like Hong Kong and China Gas commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Hong Kong and China Gas is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 4 warning signs for Hong Kong and China Gas you should be aware of, and 1 of them doesn't sit too well with us.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.