Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that ENN Energy Holdings Limited (HKG:2688) does use debt in its business. But the real question is whether this debt is making the company risky.
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. 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. 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 ENN Energy Holdings's Debt?
As you can see below, at the end of December 2018, ENN Energy Holdings had CN¥20.6b of debt, up from CN¥19.6b a year ago. Click the image for more detail. However, it does have CN¥8.67b in cash offsetting this, leading to net debt of about CN¥11.9b.
How Healthy Is ENN Energy Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that ENN Energy Holdings had liabilities of CN¥33.0b due within 12 months and liabilities of CN¥15.3b due beyond that. Offsetting this, it had CN¥8.67b in cash and CN¥7.91b in receivables that were due within 12 months. So it has liabilities totalling CN¥31.8b more than its cash and near-term receivables, combined.
This deficit isn't so bad because ENN Energy Holdings is worth a massive CN¥78.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
ENN Energy Holdings's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 50.2 times, makes us even more comfortable. One way ENN Energy Holdings could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 14%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine ENN Energy Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, ENN Energy Holdings's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
When it comes to the balance sheet, the standout positive for ENN Energy Holdings was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. It's also worth noting that ENN Energy Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that ENN Energy Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that ENN Energy Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying 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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