Here's Why Huaneng Lancang River Hydropower (SHSE:600025) Has A Meaningful Debt Burden

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. As with many other companies Huaneng Lancang River Hydropower Inc. (SHSE:600025) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Huaneng Lancang River Hydropower

What Is Huaneng Lancang River Hydropower's Net Debt?

As you can see below, at the end of June 2024, Huaneng Lancang River Hydropower had CN¥119.5b of debt, up from CN¥91.3b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Huaneng Lancang River Hydropower's Balance Sheet?

According to the last reported balance sheet, Huaneng Lancang River Hydropower had liabilities of CN¥33.0b due within 12 months, and liabilities of CN¥96.5b due beyond 12 months. On the other hand, it had cash of CN¥2.02b and CN¥4.82b worth of receivables due within a year. So it has liabilities totalling CN¥122.7b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of CN¥187.4b, so it does suggest shareholders should keep an eye on Huaneng Lancang River Hydropower's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 6.3, it's fair to say Huaneng Lancang River Hydropower does have a significant amount of debt. However, its interest coverage of 5.3 is reasonably strong, which is a good sign. If Huaneng Lancang River Hydropower can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. 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 Huaneng Lancang River Hydropower'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.

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. Looking at the most recent three years, Huaneng Lancang River Hydropower recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Huaneng Lancang River Hydropower's struggle handle its debt, based on its EBITDA, had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. Taking the abovementioned factors together we do think Huaneng Lancang River Hydropower's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Huaneng Lancang River Hydropower (of which 1 shouldn't be ignored!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.