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. We can see that The Hong Kong and China Gas Company Limited (HKG:3) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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 Hong Kong and China Gas

What Is Hong Kong and China Gas's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Hong Kong and China Gas had debt of HK$58.3b, up from HK$51.9b in one year. On the flip side, it has HK$10.2b in cash leading to net debt of about HK$48.1b.

How Strong Is Hong Kong and China Gas' Balance Sheet?

According to the last reported balance sheet, Hong Kong and China Gas had liabilities of HK$35.1b due within 12 months, and liabilities of HK$51.7b due beyond 12 months. Offsetting this, it had HK$10.2b in cash and HK$8.79b in receivables that were due within 12 months. So its liabilities total HK$67.8b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Hong Kong and China Gas has a huge market capitalization of HK$137.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Hong Kong and China Gas's debt is 4.1 times its EBITDA, and its EBIT cover its interest expense 6.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Hong Kong and China Gas saw its EBIT slide 5.9% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hong Kong and China Gas's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Hong Kong and China Gas recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Hong Kong and China Gas's net debt to EBITDA and its EBIT growth rate were discouraging. At least its interest cover gives us reason to be optimistic. We should also note that Gas Utilities industry companies like Hong Kong and China Gas commonly do use debt without problems. Taking the abovementioned factors together we do think Hong Kong and China Gas'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. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Hong Kong and China Gas (2 are a bit concerning) 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. 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.