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. Importantly, Beijing Enterprises Water Group Limited (HKG:371) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is Beijing Enterprises Water Group's Net Debt?
As you can see below, at the end of December 2018, Beijing Enterprises Water Group had HK$55.8b of debt, up from HK$44.1b a year ago. Click the image for more detail. On the flip side, it has HK$12.9b in cash leading to net debt of about HK$42.9b.
A Look At Beijing Enterprises Water Group's Liabilities
We can see from the most recent balance sheet that Beijing Enterprises Water Group had liabilities of HK$36.5b falling due within a year, and liabilities of HK$52.1b due beyond that. Offsetting these obligations, it had cash of HK$12.9b as well as receivables valued at HK$10.5b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$65.2b.
This deficit casts a shadow over the HK$41.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Beijing Enterprises Water Group 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 5.5, it's fair to say Beijing Enterprises Water Group does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.5 times, suggesting it can responsibly service its obligations. Importantly, Beijing Enterprises Water Group grew its EBIT by 38% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Beijing Enterprises Water Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Beijing Enterprises Water Group 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.
On the face of it, Beijing Enterprises Water Group's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Water Utilities industry companies like Beijing Enterprises Water Group commonly do use debt without problems. We're quite clear that we consider Beijing Enterprises Water Group to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given Beijing Enterprises Water Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.