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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Hong Kong and China Gas

What Is Hong Kong and China Gas's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Hong Kong and China Gas had HK$61.5b of debt, an increase on HK$58.3b, over one year. However, because it has a cash reserve of HK$12.2b, its net debt is less, at about HK$49.3b.

How Healthy 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$38.3b due within 12 months and liabilities of HK$52.1b due beyond that. On the other hand, it had cash of HK$12.2b and HK$13.8b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$64.4b.

This deficit is considerable relative to its very significant market capitalization of HK$106.2b, so it does suggest shareholders should keep an eye on Hong Kong and China Gas' 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). 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 5.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably Hong Kong and China Gas's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 29% 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 net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Hong Kong and China Gas you should know about.

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.