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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies China Datang Corporation Renewable Power Co., Limited (HKG:1798) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does China Datang Renewable Power Carry?
You can click the graphic below for the historical numbers, but it shows that China Datang Renewable Power had CN¥37.8b of debt in March 2019, down from CN¥47.9b, one year before. However, because it has a cash reserve of CN¥3.35b, its net debt is less, at about CN¥34.4b.
A Look At China Datang Renewable Power's Liabilities
According to the last reported balance sheet, China Datang Renewable Power had liabilities of CN¥20.5b due within 12 months, and liabilities of CN¥38.6b due beyond 12 months. Offsetting this, it had CN¥3.35b in cash and CN¥9.21b in receivables that were due within 12 months. So it has liabilities totalling CN¥46.5b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥5.01b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Datang Renewable Power would likely require a major re-capitalisation if it had to pay its creditors today.
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). 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).
While we wouldn't worry about China Datang Renewable Power's net debt to EBITDA ratio of 4.6, we think its super-low interest cover of 1.9 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, one redeeming factor is that China Datang Renewable Power grew its EBIT at 14% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Datang Renewable Power's ability to maintain a healthy balance sheet going forward. 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 Datang Renewable Power 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.
To be frank both China Datang Renewable Power'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. But at least it's pretty decent at growing its EBIT; that's encouraging. After considering the datapoints discussed, we think China Datang Renewable Power has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Over time, share prices tend to follow earnings per share, so if you're interested in China Datang Renewable Power, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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