Is Huaneng Lancang River Hydropower (SHSE:600025) Using Too Much Debt?

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 Huaneng Lancang River Hydropower Inc. (SHSE:600025) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Huaneng Lancang River Hydropower

What Is Huaneng Lancang River Hydropower's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Huaneng Lancang River Hydropower had debt of CN¥116.3b, up from CN¥87.8b in one year. And it doesn't have much cash, so its net debt is about the same.

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

Zooming in on the latest balance sheet data, we can see that Huaneng Lancang River Hydropower had liabilities of CN¥30.5b due within 12 months and liabilities of CN¥94.2b due beyond that. Offsetting this, it had CN¥2.28b in cash and CN¥2.87b in receivables that were due within 12 months. So it has liabilities totalling CN¥119.6b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of CN¥189.5b, 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 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.

With a net debt to EBITDA ratio of 6.4, it's fair to say Huaneng Lancang River Hydropower does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.1 times, suggesting it can responsibly service its obligations. Importantly Huaneng Lancang River Hydropower's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish 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 Huaneng Lancang River Hydropower 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Huaneng Lancang River Hydropower recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Huaneng Lancang River Hydropower's net debt to EBITDA was disappointing. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Once we consider all the factors above, together, it seems to us that Huaneng Lancang River Hydropower's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Huaneng Lancang River Hydropower (1 is potentially serious!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.