We Think China Gas Holdings (HKG:384) Can Stay On Top Of Its Debt

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, China Gas Holdings Limited (HKG:384) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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 China Gas Holdings

What Is China Gas Holdings's Net Debt?

As you can see below, at the end of September 2020, China Gas Holdings had HK$41.5b of debt, up from HK$38.7b a year ago. Click the image for more detail. However, it also had HK$8.44b in cash, and so its net debt is HK$33.1b.

How Healthy Is China Gas Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Gas Holdings had liabilities of HK$46.8b due within 12 months and liabilities of HK$25.8b due beyond that. Offsetting this, it had HK$8.44b in cash and HK$25.2b in receivables that were due within 12 months. So it has liabilities totalling HK$39.0b more than its cash and near-term receivables, combined.

This deficit isn't so bad because China Gas Holdings is worth a massive HK$161.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

China Gas Holdings's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 10.3 times, makes us even more comfortable. If China Gas Holdings can keep growing EBIT at last year's rate of 16% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Gas Holdings can strengthen its balance sheet over time. 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. Over the last three years, China Gas Holdings reported free cash flow worth 6.6% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both China Gas Holdings's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. It's also worth noting that China Gas Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Considering this range of data points, we think China Gas Holdings is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for China Gas Holdings you should be aware of.

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. 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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