Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that Towngas China Company Limited (HKG: 1083) uses debt in his business. But the most important question is: what risk does this debt create?
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. Ultimately, if the company can’t meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first look at cash and debt levels, together.
Check out our latest analysis for Towngas China
What is the debt of Towngas China?
As you can see below, at the end of June 2021, Towngas China had HK $ 17.3 billion in debt, up from HK $ 10.6 billion a year ago. Click on the image for more details. However, he has HK $ 2.51 billion in cash offsetting this, leading to net debt of around HK $ 14.8 billion.
How healthy is Towngas China’s balance sheet?
The latest balance sheet data shows Towngas China had HK $ 18.4 billion in liabilities due within one year, and HK $ 7.78 billion in liabilities due thereafter. In return, he had HK $ 2.51 billion in cash and HK $ 1.94 billion in receivables due within 12 months. Its liabilities therefore total HK $ 21.7 billion more than the combination of its cash and short-term receivables.
Given that this deficit is actually greater than the company’s market cap of HK $ 16.8 billion, we believe shareholders should really watch Towngas China debt levels, like a parent watching their child. riding a bike for the first time. Hypothetically, extremely high dilution would be required if the company was forced to repay its debts by raising capital at the current share price.
We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. costs (interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
With a net debt to EBITDA ratio of 5.1, it’s fair to say that Towngas China has significant debt. However, its interest coverage of 5.2 is reasonably strong, which is a good sign. It should be noted that Towngas China’s EBIT has soared like bamboo after the rain, gaining 30% in the past twelve months. This will make it easier to manage your debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Towngas China can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly examine whether this EBIT leads to the corresponding free cash flow. Over the past three years, Towngas China has experienced substantial total negative free cash flow. While investors no doubt expect this situation to reverse in due course, this clearly means its use of debt is riskier.
Our point of view
At first glance, Towngas China’s net debt to EBITDA left us hesitant about the stock, and its conversion from EBIT to free cash flow was no more attractive than the only empty restaurant at the time of the stock market. busiest night of the year. But at least it’s decent enough to increase your EBIT; it’s encouraging. It should also be noted that companies in the gas utility sector like Towngas China generally use debt without a problem. Overall, we think it’s fair to say that Towngas China has enough debt that there is real risk around the balance sheet. If all goes well it may pay off, but the downside to this debt is a greater risk of permanent losses. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, Towngas China has 2 warning signs (and 1 which is a bit obnoxious) we think you should know that.
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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