China Beidahuang Industry Group Holdings (HKG:39) Debt use could be seen as risky

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that China Beidahuang Industry Group Holdings Limited (HKG:39) has a debt on its balance sheet. But the real question is whether this debt makes the business risky.

Why is debt risky?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider cash and debt levels, together.

Check out our latest analysis for China Beidahuang Industry Group Holdings

What is the net debt of China Beidahuang Industry Group Holdings?

As you can see below, at the end of December 2021, China Beidahuang Industry Group Holdings had a debt of HK$535.9 million, compared to HK$504.9 million a year ago. Click on the image for more details. However, he also had HK$178.4 million in cash, so his net debt is HK$357.5 million.

SEHK: 39 Debt to Equity History May 31, 2022

How strong is China Beidahuang Industry Group Holdings’ balance sheet?

According to the latest published balance sheet, China Beidahuang Industry Group Holdings had liabilities of HK$1.19 billion due within 12 months and liabilities of HK$588.1 million due beyond 12 months. As compensation for these obligations, it had cash of HK$178.4 million and receivables valued at HK$426.9 million due within 12 months. It therefore has liabilities totaling HK$1.17 billion more than its cash and short-term receivables, combined.

The deficiency here weighs heavily on the company itself, worth HK$354.8 million, like a child struggling under the weight of a huge backpack full of books, his sport and a trumpet. So we definitely think shareholders need to watch this one closely. Ultimately, China Beidahuang Industry Group Holdings would likely need a major recapitalization if its creditors were to demand repayment.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

China Beidahuang Industry Group Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (6.9) and quite low interest coverage, as EBIT is only 0.30 times the interest charges. This means that we would consider him to be heavily indebted. Worse still, China Beidahuang Industry Group Holdings’ EBIT was down 26% from a year ago. If earnings continue to follow this trajectory, paying off this debt will be more difficult than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when analyzing debt. But it is the profits of China Beidahuang Industry Group Holdings that will influence the balance sheet in the future. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past two years, China Beidahuang Industry Group Holdings has actually produced more free cash flow than EBIT. This kind of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our point of view

To be frank, China Beidahuang Industry Group Holdings’ EBIT growth rate and track record of keeping total liabilities under control makes us rather uncomfortable with its level of leverage. But at least it’s decent enough to convert EBIT to free cash flow; it’s encouraging. Considering all the above factors, it seems that China Beidahuang Industry Group Holdings is too leveraged. While some investors like this kind of risky play, it’s definitely not our cup of tea. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we found 3 warning signs for China Beidahuang Industry Group Holdings (1 cannot be ignored!) which you should be aware of before investing here.

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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John A. Bogar