Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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 HK Electric Investments and HK Electric Investments Limited (HKG:2638) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is HK Electric Investments and HK Electric Investments's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 HK Electric Investments and HK Electric Investments had debt of HK$43.5b, up from HK$41.5b in one year. Net debt is about the same, since the it doesn't have much cash.
SEHK:2638 Historical Debt, October 26th 2019
A Look At HK Electric Investments and HK Electric Investments's Liabilities
According to the last reported balance sheet, HK Electric Investments and HK Electric Investments had liabilities of HK$2.94b due within 12 months, and liabilities of HK$57.3b due beyond 12 months. Offsetting this, it had HK$399.0m in cash and HK$1.38b in receivables that were due within 12 months. So its liabilities total HK$58.5b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of HK$69.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
HK Electric Investments and HK Electric Investments has a rather high debt to EBITDA ratio of 5.5 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.7 times, suggesting it can responsibly service its obligations. Unfortunately, HK Electric Investments and HK Electric Investments's EBIT flopped 15% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 HK Electric Investments and HK Electric Investments can strengthen its balance sheet over time. So if you're focused on the future you can check out this freereport showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, HK Electric Investments and HK Electric Investments produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
On the face of it, HK Electric Investments and HK Electric Investments's EBIT growth rate left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. It's also worth noting that HK Electric Investments and HK Electric Investments is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that HK Electric Investments and HK Electric Investments has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given HK Electric Investments and HK Electric Investments 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.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.
