Is Zhongyu Gas Holdings (HKG:3633) Using Too Much Debt?

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.' 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. We can see that Zhongyu Gas Holdings Limited (HKG:3633) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zhongyu Gas Holdings

What Is Zhongyu Gas Holdings's Net Debt?

As you can see below, Zhongyu Gas Holdings had HK$11.4b of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had HK$2.86b in cash, and so its net debt is HK$8.50b.

A Look At Zhongyu Gas Holdings' Liabilities

According to the last reported balance sheet, Zhongyu Gas Holdings had liabilities of HK$11.4b due within 12 months, and liabilities of HK$5.35b due beyond 12 months. On the other hand, it had cash of HK$2.86b and HK$2.79b worth of receivables due within a year. So its liabilities total HK$11.1b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Zhongyu Gas Holdings has a market capitalization of HK$21.3b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Zhongyu Gas Holdings's debt to EBITDA ratio of 5.4 suggests a heavy debt load, its interest coverage of 7.7 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. Unfortunately, Zhongyu Gas Holdings's EBIT flopped 20% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Zhongyu Gas Holdings saw substantial negative free cash flow, in total. 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 EBIT growth rate and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We should also note that Gas Utilities industry companies like Zhongyu Gas Holdings commonly do use debt without problems. Overall, it seems to us that Zhongyu Gas Holdings's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Zhongyu Gas Holdings (including 1 which shouldn't be ignored) .

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.

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.

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