Here's Why Zhongyu Energy Holdings (HKG:3633) Has A Meaningful Debt Burden

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.' 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 more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Zhongyu Energy Holdings

What Is Zhongyu Energy Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Zhongyu Energy Holdings had HK$11.5b in debt in December 2022; about the same as the year before. However, because it has a cash reserve of HK$2.99b, its net debt is less, at about HK$8.54b.

How Strong Is Zhongyu Energy Holdings' Balance Sheet?

According to the last reported balance sheet, Zhongyu Energy Holdings had liabilities of HK$10.5b due within 12 months, and liabilities of HK$6.67b due beyond 12 months. Offsetting these obligations, it had cash of HK$2.99b as well as receivables valued at HK$2.38b due within 12 months. So it has liabilities totalling HK$11.8b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$16.9b, so it does suggest shareholders should keep an eye on Zhongyu Energy Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 5.1, 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 3.9 times, suggesting it can responsibly service its obligations. Another concern for investors might be that Zhongyu Energy Holdings's EBIT fell 14% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There's no doubt that we learn most about debt from the balance sheet. But it is Zhongyu Energy Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Zhongyu Energy Holdings created free cash flow amounting to 7.9% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Zhongyu Energy Holdings's EBIT growth rate and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. And even its level of total liabilities 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, it seems to us that Zhongyu Energy Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Zhongyu Energy Holdings has 2 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.