Is Huadian Power International (HKG:1071) A Risky Investment?

Warren Buffett famously said, '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 note that Huadian Power International Corporation Limited (HKG:1071) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Huadian Power International

What Is Huadian Power International's Net Debt?

The chart below, which you can click on for greater detail, shows that Huadian Power International had CN¥106.7b in debt in March 2021; about the same as the year before. However, because it has a cash reserve of CN¥6.63b, its net debt is less, at about CN¥100.1b.

How Strong Is Huadian Power International's Balance Sheet?

According to the last reported balance sheet, Huadian Power International had liabilities of CN¥55.4b due within 12 months, and liabilities of CN¥83.6b due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.63b as well as receivables valued at CN¥14.4b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥118.0b.

The deficiency here weighs heavily on the CN¥32.4b 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 definitely think shareholders need to watch this one closely. After all, Huadian Power International would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Huadian Power International has a debt to EBITDA ratio of 4.3 and its EBIT covered its interest expense 3.4 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Huadian Power International improved its EBIT by 6.5% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Huadian Power International's ability to maintain a healthy balance sheet going forward. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Huadian Power International recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Huadian Power International's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Huadian Power International's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Huadian Power International .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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