These 4 Measures Indicate That Hong Kong and China Gas (HKG:3) Is Using Debt Reasonably Well
Simply Wall St
David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that The Hong Kong and China Gas Company Limited (HKG:3) does use debt in its business. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
The image below, which you can click on for greater detail, shows that Hong Kong and China Gas had debt of HK$38.8b at the end of June 2019, a reduction from HK$40.6b over a year. On the flip side, it has HK$7.91b in cash leading to net debt of about HK$30.9b.
SEHK:3 Historical Debt, November 5th 2019
How Strong Is Hong Kong and China Gas's Balance Sheet?
The latest balance sheet data shows that Hong Kong and China Gas had liabilities of HK$24.8b due within a year, and liabilities of HK$37.2b falling due after that. Offsetting this, it had HK$7.91b in cash and HK$7.87b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$46.2b.
Of course, Hong Kong and China Gas has a titanic market capitalization of HK$261.0b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
Hong Kong and China Gas's net debt is 2.9 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 11.5 is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. Notably Hong Kong and China Gas's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hong Kong and China Gas can strengthen its balance sheet over time. So if you're focused on the future you can check out this freereport showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Hong Kong and China Gas recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
On our analysis Hong Kong and China Gas's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. It's also worth noting that Hong Kong and China Gas is in the Gas Utilities industry, which is often considered to be quite defensive. Considering this range of data points, we think Hong Kong and China Gas is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Hong Kong and China Gas's earnings per share history for free.
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