Is China Gas Holdings (HKG:384) A Risky Investment?

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 China Gas Holdings Limited (HKG:384) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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

What Is China Gas Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 China Gas Holdings had debt of HK$49.6b, up from HK$41.5b in one year. However, it also had HK$11.7b in cash, and so its net debt is HK$37.9b.

A Look At China Gas Holdings' Liabilities

According to the last reported balance sheet, China Gas Holdings had liabilities of HK$41.2b due within 12 months, and liabilities of HK$41.1b due beyond 12 months. On the other hand, it had cash of HK$11.7b and HK$31.5b worth of receivables due within a year. So its liabilities total HK$39.1b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because China Gas Holdings is worth HK$73.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt to EBITDA of 2.7 China Gas Holdings has a fairly noticeable amount of debt. But the high interest coverage of 8.8 suggests it can easily service that debt. Unfortunately, China Gas Holdings saw its EBIT slide 8.4% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Gas Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, China Gas Holdings created free cash flow amounting to 9.8% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

While China Gas Holdings's EBIT growth rate makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at covering its interest expense with its EBIT. We should also note that Gas Utilities industry companies like China Gas Holdings commonly do use debt without problems. Taking the abovementioned factors together we do think China Gas Holdings's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 4 warning signs for China Gas Holdings you should be aware of, and 1 of them is a bit concerning.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.