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

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, The Hong Kong and China Gas Company Limited (HKG:3) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hong Kong and China Gas

What Is Hong Kong and China Gas's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Hong Kong and China Gas had debt of HK$59.8b, up from HK$56.2b in one year. On the flip side, it has HK$13.4b in cash leading to net debt of about HK$46.5b.

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$40.1b due within 12 months and liabilities of HK$49.8b due beyond that. Offsetting this, it had HK$13.4b in cash and HK$9.74b in receivables that were due within 12 months. So it has liabilities totalling HK$66.8b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Hong Kong and China Gas is worth a massive HK$134.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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 4.1 and its EBIT covered its interest expense 4.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sadly, Hong Kong and China Gas's EBIT actually dropped 5.2% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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'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 always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Hong Kong and China Gas recorded free cash flow of 34% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Hong Kong and China Gas's struggle handle its debt, based on its EBITDA, had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. We should also note that Gas Utilities industry companies like Hong Kong and China Gas commonly do use debt without problems. 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. 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. Case in point: We've spotted 2 warning signs for Hong Kong and China Gas you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.