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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Zhongyu Gas Holdings Limited (HKG:3633) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 Zhongyu Gas Holdings

What Is Zhongyu Gas Holdings's Debt?

As you can see below, Zhongyu Gas Holdings had HK$11.2b of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$2.67b in cash leading to net debt of about HK$8.49b.

A Look At Zhongyu Gas Holdings's Liabilities

According to the last reported balance sheet, Zhongyu Gas Holdings had liabilities of HK$8.23b due within 12 months, and liabilities of HK$6.87b due beyond 12 months. On the other hand, it had cash of HK$2.67b and HK$2.53b worth of receivables due within a year. So it has liabilities totalling HK$9.90b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Zhongyu Gas Holdings has a market capitalization of HK$18.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zhongyu Gas Holdings has a debt to EBITDA ratio of 4.8 and its EBIT covered its interest expense 3.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Another concern for investors might be that Zhongyu Gas Holdings's EBIT fell 11% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zhongyu Gas Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Zhongyu Gas Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Mulling over Zhongyu Gas Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its level of total liabilities is not so bad. It's also worth noting that Zhongyu Gas Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that Zhongyu Gas 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. 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. For instance, we've identified 4 warning signs for Zhongyu Gas Holdings (1 is potentially serious) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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