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 China Gas Holdings Limited (HKG:384) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, 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 March 2022 China Gas Holdings had debt of HK$56.1b, up from HK$49.0b in one year. However, because it has a cash reserve of HK$10.1b, its net debt is less, at about HK$46.0b.

A Look At China Gas Holdings' Liabilities

We can see from the most recent balance sheet that China Gas Holdings had liabilities of HK$54.3b falling due within a year, and liabilities of HK$36.8b due beyond that. Offsetting this, it had HK$10.1b in cash and HK$31.4b in receivables that were due within 12 months. So its liabilities total HK$49.6b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$61.0b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Gas Holdings's debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 6.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that China Gas Holdings's EBIT was down 23% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. 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, 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, China Gas Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

We'd go so far as to say China Gas Holdings's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. It's also worth noting that China Gas Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. We're quite clear that we consider China Gas Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 2 warning signs for China Gas Holdings (1 can't be ignored!) that you should be aware of before investing here.

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.