David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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. As with many other companies Beijing Gas Blue Sky Holdings Limited (HKG:6828) makes use of debt. But the real question is whether this debt is making the company risky.
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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Beijing Gas Blue Sky Holdings’s Net Debt?
As you can see below, at the end of June 2019, Beijing Gas Blue Sky Holdings had HK$2.54b of debt, up from HK$2.1k a year ago. Click the image for more detail. On the flip side, it has HK$774.0m in cash leading to net debt of about HK$1.76b.
A Look At Beijing Gas Blue Sky Holdings’s Liabilities
We can see from the most recent balance sheet that Beijing Gas Blue Sky Holdings had liabilities of HK$2.07b falling due within a year, and liabilities of HK$1.63b due beyond that. Offsetting this, it had HK$774.0m in cash and HK$859.7m in receivables that were due within 12 months. So it has liabilities totalling HK$2.07b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of HK$2.61b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Beijing Gas Blue Sky Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (11.1), and fairly weak interest coverage, since EBIT is just 0.11 times the interest expense. This means we’d consider it to have a heavy debt load. One redeeming factor for Beijing Gas Blue Sky Holdings is that it turned last year’s EBIT loss into a gain of HK$27m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Beijing Gas Blue Sky 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Beijing Gas Blue Sky Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Beijing Gas Blue Sky Holdings’s interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. It’s also worth noting that Beijing Gas Blue Sky Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Beijing Gas Blue Sky Holdings’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Like risks, for instance. Every company has them, and we’ve spotted 2 warning signs for Beijing Gas Blue Sky Holdings (of which 1 doesn’t sit too well with us!) you should know about.
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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