Is Hong Kong and China Gas (HKG:3) A Risky Investment?

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.' 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 note that The Hong Kong and China Gas Company Limited (HKG:3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Hong Kong and China Gas

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

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Hong Kong and China Gas had HK$58.3b of debt, an increase on HK$51.9b, over one year. However, because it has a cash reserve of HK$10.2b, its net debt is less, at about HK$48.1b.

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$35.1b due within 12 months, and liabilities of HK$51.7b due beyond 12 months. On the other hand, it had cash of HK$10.2b and HK$8.79b worth of receivables due within a year. So its liabilities total HK$67.8b more than the combination of its cash and short-term receivables.

Hong Kong and China Gas has a very large market capitalization of HK$137.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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 a debt to EBITDA ratio of 4.1 and its EBIT covered its interest expense 6.9 times. 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 that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Hong Kong and China Gas's free cash flow amounted to 33% 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 EBIT growth rate were discouraging. At least its interest cover gives us reason to be optimistic. 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. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Hong Kong and China Gas you should be aware of, and 2 of them are concerning.

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.

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.