These 4 Measures Indicate That Hong Kong and China Gas (HKG:3) Is Using Debt Reasonably Well

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, The Hong Kong and China Gas Company Limited (HKG:3) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hong Kong and China Gas

How Much Debt Does Hong Kong and China Gas Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Hong Kong and China Gas had debt of HK$43.2b, up from HK$39.6b in one year. However, it also had HK$7.83b in cash, and so its net debt is HK$35.4b.

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$29.8b due within 12 months and liabilities of HK$41.3b due beyond that. On the other hand, it had cash of HK$7.83b and HK$7.46b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$55.8b.

This deficit isn't so bad because Hong Kong and China Gas is worth a massive HK$218.6b, 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.

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). 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 3.2 times its EBITDA, and its EBIT cover its interest expense 6.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Hong Kong and China Gas grew its EBIT by 4.7% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Hong Kong and China Gas recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Hong Kong and China Gas's net debt to EBITDA was a real negative on this analysis, as was its conversion of EBIT to free cash flow. Balancing that a bit, it has a demonstrated ability interest cover. We would also note that Gas Utilities industry companies like Hong Kong and China Gas commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Hong Kong and China Gas's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. 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 you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. 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.
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