Here's Why Chaowei Power Holdings (HKG:951) Has A Meaningful Debt Burden

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.' 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. As with many other companies Chaowei Power Holdings Limited (HKG:951) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Chaowei Power Holdings

What Is Chaowei Power Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Chaowei Power Holdings had debt of CN¥6.29b, up from CN¥5.16b in one year. However, it does have CN¥2.83b in cash offsetting this, leading to net debt of about CN¥3.46b.

How Strong Is Chaowei Power Holdings' Balance Sheet?

We can see from the most recent balance sheet that Chaowei Power Holdings had liabilities of CN¥11.5b falling due within a year, and liabilities of CN¥1.67b due beyond that. Offsetting these obligations, it had cash of CN¥2.83b as well as receivables valued at CN¥3.28b due within 12 months. So it has liabilities totalling CN¥7.08b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥2.70b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Chaowei Power Holdings would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chaowei Power Holdings has net debt worth 2.1 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.0 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. If Chaowei Power Holdings 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 you can't view debt in total isolation; since Chaowei Power Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Chaowei Power Holdings generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Neither Chaowei Power Holdings's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Chaowei Power Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Chaowei Power Holdings (including 1 which can't be ignored) .

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. 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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