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. We note that Chi Ho Development Holdings Limited (HKG:8423) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Chi Ho Development Holdings
How Much Debt Does Chi Ho Development Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2024 Chi Ho Development Holdings had HK$104.9m of debt, an increase on HK$89.0m, over one year. However, because it has a cash reserve of HK$13.7m, its net debt is less, at about HK$91.2m.
How Healthy Is Chi Ho Development Holdings' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Chi Ho Development Holdings had liabilities of HK$255.7m due within 12 months and liabilities of HK$942.0k due beyond that. Offsetting this, it had HK$13.7m in cash and HK$318.6m in receivables that were due within 12 months. So it actually has HK$75.7m more liquid assets than total liabilities.
This surplus liquidity suggests that Chi Ho Development Holdings' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet means the company is able to handle some adversity.
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.
Chi Ho Development Holdings's debt is 4.6 times its EBITDA, and its EBIT cover its interest expense 5.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We note that Chi Ho Development Holdings grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Chi Ho Development 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Chi Ho Development Holdings recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
The good news is that Chi Ho Development Holdings's demonstrated ability to handle its total liabilities delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its net debt to EBITDA. Considering this range of factors, it seems to us that Chi Ho Development Holdings is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. 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. To that end, you should learn about the 3 warning signs we've spotted with Chi Ho Development Holdings (including 2 which make us uncomfortable) .
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.