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. 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 Huadian Power International Corporation Limited (HKG:1071) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Huadian Power International's Debt?
The image below, which you can click on for greater detail, shows that Huadian Power International had debt of CN¥119.5b at the end of June 2019, a reduction from CN¥130.9b over a year. However, it does have CN¥9.31b in cash offsetting this, leading to net debt of about CN¥110.2b.
How Strong Is Huadian Power International's Balance Sheet?
We can see from the most recent balance sheet that Huadian Power International had liabilities of CN¥73.9b falling due within a year, and liabilities of CN¥82.1b due beyond that. On the other hand, it had cash of CN¥9.31b and CN¥12.1b worth of receivables due within a year. So it has liabilities totalling CN¥134.6b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the CN¥34.5b 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 definitely think shareholders need to watch this one closely. At the end of the day, Huadian Power International would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 5.7 hit our confidence in Huadian Power International like a one-two punch to the gut. The debt burden here is substantial. On a slightly more positive note, Huadian Power International grew its EBIT at 16% over the last year, further increasing its ability to manage debt. 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 Huadian Power International 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Huadian Power International recorded free cash flow of 20% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Huadian Power International's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Huadian Power International to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Over time, share prices tend to follow earnings per share, so if you're interested in Huadian Power International, 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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