Chongqing Three Gorges Water Conservancy and Electric Power (SHSE:600116) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Chongqing Three Gorges Water Conservancy and Electric Power Co., Ltd. (SHSE:600116) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Chongqing Three Gorges Water Conservancy and Electric Power

What Is Chongqing Three Gorges Water Conservancy and Electric Power's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Chongqing Three Gorges Water Conservancy and Electric Power had CN¥9.32b of debt, an increase on CN¥8.10b, over one year. On the flip side, it has CN¥1.94b in cash leading to net debt of about CN¥7.38b.

A Look At Chongqing Three Gorges Water Conservancy and Electric Power's Liabilities

We can see from the most recent balance sheet that Chongqing Three Gorges Water Conservancy and Electric Power had liabilities of CN¥7.72b falling due within a year, and liabilities of CN¥4.85b due beyond that. Offsetting these obligations, it had cash of CN¥1.94b as well as receivables valued at CN¥2.44b due within 12 months. So it has liabilities totalling CN¥8.19b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥13.6b, so it does suggest shareholders should keep an eye on Chongqing Three Gorges Water Conservancy and Electric Power's use of debt. 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). 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).

Chongqing Three Gorges Water Conservancy and Electric Power has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. However, its interest coverage of 4.0 is reasonably strong, which is a good sign. Looking on the bright side, Chongqing Three Gorges Water Conservancy and Electric Power boosted its EBIT by a silky 47% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 Chongqing Three Gorges Water Conservancy and Electric Power's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Chongqing Three Gorges Water Conservancy and Electric Power burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Chongqing Three Gorges Water Conservancy and Electric Power's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. It's also worth noting that Chongqing Three Gorges Water Conservancy and Electric Power is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Chongqing Three Gorges Water Conservancy and Electric Power's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 3 warning signs for Chongqing Three Gorges Water Conservancy and Electric Power you should be aware of, and 1 of them can't be ignored.

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.

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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.

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