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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that China Conch Venture Holdings Limited (HKG:586) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is China Conch Venture Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2023 China Conch Venture Holdings had CN¥27.0b of debt, an increase on CN¥22.1b, over one year. However, it does have CN¥3.71b in cash offsetting this, leading to net debt of about CN¥23.3b.
How Healthy Is China Conch Venture Holdings' Balance Sheet?
According to the last reported balance sheet, China Conch Venture Holdings had liabilities of CN¥6.45b due within 12 months, and liabilities of CN¥26.3b due beyond 12 months. Offsetting these obligations, it had cash of CN¥3.71b as well as receivables valued at CN¥3.97b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥25.0b.
This deficit casts a shadow over the CN¥8.83b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Conch Venture Holdings 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
China Conch Venture Holdings has a rather high debt to EBITDA ratio of 8.6 which suggests a meaningful debt load. However, its interest coverage of 2.9 is reasonably strong, which is a good sign. More concerning, China Conch Venture Holdings saw its EBIT drop by 5.4% 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Conch Venture Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Conch Venture Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
To be frank both China Conch Venture Holdings's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Considering all the factors previously mentioned, we think that China Conch Venture Holdings really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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 3 warning signs for China Conch Venture Holdings (1 can't be ignored) you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.
