The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, The Hong Kong and China Gas Company Limited (HKG:3) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

How Much Debt Does Hong Kong and China Gas Carry?

You can click the graphic below for the historical numbers, but it shows that Hong Kong and China Gas had HK$56.3b of debt in December 2023, down from HK$60.1b, one year before. However, it does have HK$10.4b in cash offsetting this, leading to net debt of about HK$45.9b.

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

We can see from the most recent balance sheet that Hong Kong and China Gas had liabilities of HK$40.1b falling due within a year, and liabilities of HK$50.8b due beyond that. Offsetting this, it had HK$10.4b in cash and HK$9.63b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$70.9b.

This deficit is considerable relative to its very significant market capitalization of HK$112.1b, so it does suggest shareholders should keep an eye on Hong Kong and China Gas' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 has a debt to EBITDA ratio of 4.0 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. More concerning, Hong Kong and China Gas saw its EBIT drop by 2.7% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Hong Kong and China Gas's free cash flow amounted to 20% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Hong Kong and China Gas's conversion of EBIT to free cash flow left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. We should also note that Gas Utilities industry companies like Hong Kong and China Gas commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Hong Kong and China Gas's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Hong Kong and China Gas that you should be aware of.

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.