Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies China Gas Holdings Limited (HKG:384) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is China Gas Holdings's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 China Gas Holdings had debt of HK$60.6b, up from HK$55.4b in one year. However, it also had HK$9.23b in cash, and so its net debt is HK$51.4b.

How Healthy Is China Gas Holdings' Balance Sheet?

The latest balance sheet data shows that China Gas Holdings had liabilities of HK$47.8b due within a year, and liabilities of HK$41.5b falling due after that. Offsetting this, it had HK$9.23b in cash and HK$25.6b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$54.5b.

This deficit casts a shadow over the HK$35.1b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Gas Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 6.2, it's fair to say China Gas Holdings does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.6 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that China Gas Holdings grew its EBIT at 18% over the last 12 months, boosting its ability to handle its debt. 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 China Gas Holdings'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. During the last three years, China Gas Holdings produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both China Gas Holdings's net debt to EBITDA and its level of total liabilities were discouraging. But at least its conversion of EBIT to free cash flow is a gleaming silver lining to those clouds. It's also worth noting that China Gas Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think China Gas Holdings's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with China Gas Holdings (including 1 which can't be ignored) .

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.