Stock Analysis

Perennial Energy Holdings (HKG:2798) Has A Pretty Healthy Balance Sheet

SEHK:2798
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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. We can see that Perennial Energy Holdings Limited (HKG:2798) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Perennial Energy Holdings

What Is Perennial Energy Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 Perennial Energy Holdings had CN¥522.0m of debt, an increase on CN¥376.9m, over one year. However, because it has a cash reserve of CN¥180.9m, its net debt is less, at about CN¥341.2m.

debt-equity-history-analysis
SEHK:2798 Debt to Equity History June 18th 2022

A Look At Perennial Energy Holdings' Liabilities

The latest balance sheet data shows that Perennial Energy Holdings had liabilities of CN¥726.4m due within a year, and liabilities of CN¥743.5m falling due after that. Offsetting this, it had CN¥180.9m in cash and CN¥434.5m in receivables that were due within 12 months. So it has liabilities totalling CN¥854.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Perennial Energy Holdings is worth CN¥2.53b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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

Perennial Energy Holdings's net debt is only 0.40 times its EBITDA. And its EBIT covers its interest expense a whopping 35.9 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Perennial Energy Holdings grew its EBIT by 49% over the last twelve months, and that growth will make it easier to handle its debt. 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 Perennial Energy Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Perennial Energy Holdings burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Based on what we've seen Perennial Energy Holdings is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Perennial Energy Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Perennial Energy Holdings , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Valuation is complex, but we're helping make it simple.

Find out whether Perennial Energy Holdings is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.