SPT Energy Group (HKG:1251) Takes On Some Risk With Its Use Of 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.' 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 note that SPT Energy Group Inc. (HKG:1251) does have debt on its balance sheet. 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 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. 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.

View our latest analysis for SPT Energy Group

What Is SPT Energy Group's Debt?

The image below, which you can click on for greater detail, shows that at December 2021 SPT Energy Group had debt of CN¥577.9m, up from CN¥491.3m in one year. However, it also had CN¥430.3m in cash, and so its net debt is CN¥147.6m.

How Strong Is SPT Energy Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that SPT Energy Group had liabilities of CN¥1.29b due within 12 months and liabilities of CN¥286.9m due beyond that. On the other hand, it had cash of CN¥430.3m and CN¥1.03b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥121.4m.

SPT Energy Group has a market capitalization of CN¥495.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Even though SPT Energy Group's debt is only 1.5, its interest cover is really very low at 1.3. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. We also note that SPT Energy Group improved its EBIT from a last year's loss to a positive CN¥52m. 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 SPT Energy Group 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, SPT Energy Group barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Our View

SPT Energy Group's interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its net debt to EBITDA is relatively strong. When we consider all the factors discussed, it seems to us that SPT Energy Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that SPT Energy Group is showing 1 warning sign in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.