Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, China Tobacco International (HK) Company Limited (HKG:6055) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for China Tobacco International (HK)

How Much Debt Does China Tobacco International (HK) Carry?

As you can see below, at the end of June 2022, China Tobacco International (HK) had HK$2.08b of debt, up from none a year ago. Click the image for more detail. On the flip side, it has HK$2.02b in cash leading to net debt of about HK$60.3m.

How Strong Is China Tobacco International (HK)'s Balance Sheet?

The latest balance sheet data shows that China Tobacco International (HK) had liabilities of HK$4.02b due within a year, and liabilities of HK$87.4m falling due after that. Offsetting this, it had HK$2.02b in cash and HK$1.20b in receivables that were due within 12 months. So it has liabilities totalling HK$886.4m more than its cash and near-term receivables, combined.

Since publicly traded China Tobacco International (HK) shares are worth a total of HK$7.59b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, China Tobacco International (HK) has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). 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).

China Tobacco International (HK) has a low net debt to EBITDA ratio of only 0.10. And its EBIT covers its interest expense a whopping 17.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, China Tobacco International (HK) grew its EBIT by 218% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Tobacco International (HK) can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, China Tobacco International (HK)'s free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that China Tobacco International (HK)'s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at the bigger picture, we think China Tobacco International (HK)'s use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of China Tobacco International (HK)'s earnings per share history for free.

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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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.