Here's Why China Telecom (HKG:728) Has A Meaningful Debt Burden
The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 China Telecom Corporation Limited (HKG:728) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for China Telecom
What Is China Telecom's Debt?
The image below, which you can click on for greater detail, shows that China Telecom had debt of CN¥31.2b at the end of March 2020, a reduction from CN¥67.3b over a year. But it also has CN¥35.6b in cash to offset that, meaning it has CN¥4.44b net cash.
A Look At China Telecom's Liabilities
According to the last reported balance sheet, China Telecom had liabilities of CN¥265.3b due within 12 months, and liabilities of CN¥90.2b due beyond 12 months. On the other hand, it had cash of CN¥35.6b and CN¥39.5b worth of receivables due within a year. So its liabilities total CN¥280.4b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CN¥177.8b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, China Telecom would likely require a major re-capitalisation if it had to pay its creditors today. China Telecom boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.
Fortunately, China Telecom grew its EBIT by 2.4% in the last year, making that debt load look even more manageable. 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 Telecom 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. China Telecom may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, China Telecom produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Summing up
Although China Telecom's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥4.44b. And it impressed us with free cash flow of CN¥37b, being 71% of its EBIT. So while China Telecom does not have a great balance sheet, it's certainly not too bad. 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 1 warning sign for China Telecom that you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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This article by Simply Wall St is general in nature. 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. Thank you for reading.
