Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Energy International Investments Holdings Limited (HKG:353) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Energy International Investments Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that Energy International Investments Holdings had debt of HK$353.1m at the end of June 2019, a reduction from HK$709.5m over a year. However, it does have HK$30.3m in cash offsetting this, leading to net debt of about HK$322.9m.
A Look At Energy International Investments Holdings's Liabilities
We can see from the most recent balance sheet that Energy International Investments Holdings had liabilities of HK$732.0m falling due within a year, and liabilities of HK$173.7m due beyond that. Offsetting these obligations, it had cash of HK$30.3m as well as receivables valued at HK$73.9m due within 12 months. So its liabilities total HK$801.5m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of HK$1.06b, so it does suggest shareholders should keep an eye on Energy International Investments Holdings's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Even though Energy International Investments Holdings's debt is only 2.4, its interest cover is really very low at 0.73. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. One redeeming factor for Energy International Investments Holdings is that it turned last year's EBIT loss into a gain of HK$35m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Energy International Investments Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Energy International Investments Holdings burned a lot of cash. 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 Energy International Investments Holdings's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Overall, it seems to us that Energy International Investments Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Even though Energy International Investments Holdings lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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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