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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Zhongyu Gas Holdings Limited (HKG:3633) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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.

View our latest analysis for Zhongyu Gas Holdings

How Much Debt Does Zhongyu Gas Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Zhongyu Gas Holdings had HK$11.6b of debt, an increase on HK$11.0b, over one year. However, it also had HK$2.49b in cash, and so its net debt is HK$9.10b.

A Look At Zhongyu Gas Holdings' Liabilities

We can see from the most recent balance sheet that Zhongyu Gas Holdings had liabilities of HK$11.5b falling due within a year, and liabilities of HK$5.44b due beyond that. On the other hand, it had cash of HK$2.49b and HK$2.45b worth of receivables due within a year. So it has liabilities totalling HK$12.0b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$17.4b, so it does suggest shareholders should keep an eye on Zhongyu Gas Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 5.4, it's fair to say Zhongyu Gas Holdings does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.7 times, suggesting it can responsibly service its obligations. Importantly Zhongyu Gas Holdings's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Zhongyu Gas Holdings will need earnings to service that debt. 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.

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. During the last three years, Zhongyu Gas Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Zhongyu Gas Holdings's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. It's also worth noting that Zhongyu Gas Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Zhongyu Gas Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Zhongyu Gas Holdings (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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. 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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