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. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Xinte Energy Co., Ltd. (HKG:1799) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Xinte Energy's Debt?
The chart below, which you can click on for greater detail, shows that Xinte Energy had CN¥13.0b in debt in June 2019; about the same as the year before. However, it does have CN¥3.56b in cash offsetting this, leading to net debt of about CN¥9.42b.
A Look At Xinte Energy's Liabilities
We can see from the most recent balance sheet that Xinte Energy had liabilities of CN¥12.7b falling due within a year, and liabilities of CN¥10.7b due beyond that. Offsetting these obligations, it had cash of CN¥3.56b as well as receivables valued at CN¥5.98b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥13.8b.
The deficiency here weighs heavily on the CN¥5.54b 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, Xinte Energy would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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).
Xinte Energy shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 2.2 times the interest expense. The debt burden here is substantial. Worse, Xinte Energy's EBIT was down 50% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xinte Energy 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 that EBIT is backed by free cash flow. During the last three years, Xinte Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Xinte Energy's EBIT growth rate 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. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that Xinte Energy is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Xinte Energy's dividend history, without delay!
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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