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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 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 CITIC Dameng Holdings Limited (HKG:1091) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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 think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for CITIC Dameng Holdings
What Is CITIC Dameng Holdings's Net Debt?
As you can see below, CITIC Dameng Holdings had HK$4.45b of debt at June 2019, down from HK$4.71b a year prior. However, because it has a cash reserve of HK$1.53b, its net debt is less, at about HK$2.92b.
How Strong Is CITIC Dameng Holdings's Balance Sheet?
The latest balance sheet data shows that CITIC Dameng Holdings had liabilities of HK$5.48b due within a year, and liabilities of HK$1.19b falling due after that. Offsetting these obligations, it had cash of HK$1.53b as well as receivables valued at HK$1.89b due within 12 months. So its liabilities total HK$3.25b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$1.17b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, CITIC Dameng Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While CITIC Dameng Holdings's debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that CITIC Dameng Holdings actually grew its EBIT by a hefty 232%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since CITIC Dameng Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.