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. Importantly, China Infrastructure & Logistics Group Ltd. (HKG:1719) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
View our latest analysis for China Infrastructure & Logistics Group
What Is China Infrastructure & Logistics Group’s Debt?
As you can see below, at the end of June 2020, China Infrastructure & Logistics Group had HK$526.1m of debt, up from HK$486.0m a year ago. Click the image for more detail. On the flip side, it has HK$74.0m in cash leading to net debt of about HK$452.1m.
A Look At China Infrastructure & Logistics Group’s Liabilities
We can see from the most recent balance sheet that China Infrastructure & Logistics Group had liabilities of HK$577.3m falling due within a year, and liabilities of HK$334.8m due beyond that. Offsetting this, it had HK$74.0m in cash and HK$204.2m in receivables that were due within 12 months. So it has liabilities totalling HK$633.9m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since China Infrastructure & Logistics Group has a market capitalization of HK$1.54b, 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 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 1.3 times and a disturbingly high net debt to EBITDA ratio of 8.2 hit our confidence in China Infrastructure & Logistics Group like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Even worse, China Infrastructure & Logistics Group saw its EBIT tank 35% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Infrastructure & Logistics 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, China Infrastructure & Logistics Group produced sturdy free cash flow equating to 77% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
To be frank both China Infrastructure & Logistics Group’s net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. It’s also worth noting that China Infrastructure & Logistics Group is in the Infrastructure industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that China Infrastructure & Logistics Group’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. 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. Take risks, for example – China Infrastructure & Logistics Group has 4 warning signs (and 2 which make us uncomfortable) we think you should know about.
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. 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.
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