Does Zhongyu Energy Holdings (HKG:3633) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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, Zhongyu Energy Holdings Limited (HKG:3633) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Zhongyu Energy Holdings

What Is Zhongyu Energy Holdings's Debt?

As you can see below, at the end of June 2023, Zhongyu Energy Holdings had HK$12.4b of debt, up from HK$11.4b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$3.60b, its net debt is less, at about HK$8.80b.

How Strong Is Zhongyu Energy Holdings' Balance Sheet?

The latest balance sheet data shows that Zhongyu Energy Holdings had liabilities of HK$8.56b due within a year, and liabilities of HK$9.05b falling due after that. On the other hand, it had cash of HK$3.60b and HK$2.43b worth of receivables due within a year. So it has liabilities totalling HK$11.6b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of HK$14.7b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

With a net debt to EBITDA ratio of 5.0, it's fair to say Zhongyu Energy Holdings does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. More concerning, Zhongyu Energy Holdings saw its EBIT drop by 7.1% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Zhongyu Energy Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, Zhongyu Energy Holdings recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Zhongyu Energy Holdings's interest cover and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. And even its EBIT growth rate fails to inspire much confidence. We should also note that Gas Utilities industry companies like Zhongyu Energy Holdings commonly do use debt without problems. Overall, we think it's fair to say that Zhongyu Energy Holdings has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zhongyu Energy Holdings is showing 3 warning signs in our investment analysis , and 2 of those 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.