Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 note that Zhuguang Holdings Group Company Limited (HKG:1176) does have debt on its balance sheet. But is this debt a concern to shareholders?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Zhuguang Holdings Group
What Is Zhuguang Holdings Group's Debt?
You can click the graphic below for the historical numbers, but it shows that Zhuguang Holdings Group had HK$14.8b of debt in June 2023, down from HK$17.9b, one year before. However, it does have HK$663.3m in cash offsetting this, leading to net debt of about HK$14.1b.
How Strong Is Zhuguang Holdings Group's Balance Sheet?
The latest balance sheet data shows that Zhuguang Holdings Group had liabilities of HK$19.7b due within a year, and liabilities of HK$9.30b falling due after that. On the other hand, it had cash of HK$663.3m and HK$10.6b worth of receivables due within a year. So it has liabilities totalling HK$17.8b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$5.49b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Zhuguang Holdings Group would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 11.9 hit our confidence in Zhuguang Holdings Group like a one-two punch to the gut. The debt burden here is substantial. Given the debt load, it's hardly ideal that Zhuguang Holdings Group's EBIT was pretty flat over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Zhuguang Holdings Group's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Zhuguang Holdings Group recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Our View
On the face of it, Zhuguang Holdings Group's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Zhuguang Holdings Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zhuguang Holdings Group is showing 3 warning signs in our investment analysis , 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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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.