Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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. We can see that Huaneng Power International, Inc. (HKG:902) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Huaneng Power International Carry?
As you can see below, at the end of September 2019, Huaneng Power International had CN¥249.4b of debt, up from CN¥239.2b a year ago. Click the image for more detail. However, it does have CN¥15.9b in cash offsetting this, leading to net debt of about CN¥233.5b.
How Strong Is Huaneng Power International’s Balance Sheet?
The latest balance sheet data shows that Huaneng Power International had liabilities of CN¥142.3b due within a year, and liabilities of CN¥152.5b falling due after that. Offsetting this, it had CN¥15.9b in cash and CN¥29.6b in receivables that were due within 12 months. So its liabilities total CN¥249.3b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥79.7b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt At the end of the day, Huaneng Power International would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
Huaneng Power International shareholders face the double whammy of a high net debt to EBITDA ratio (6.3), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. This means we’d consider it to have a heavy debt load. On the other hand, Huaneng Power International grew its EBIT by 22% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. 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 Huaneng Power International can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Huaneng Power International’s free cash flow amounted to 44% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
On the face of it, Huaneng 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 at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, it seems to us that Huaneng Power International’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. Over time, share prices tend to follow earnings per share, so if you’re interested in Huaneng Power International, you may well want to click here to check an interactive graph of its earnings per share history.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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