We Think Huadian Power International (HKG:1071) Is Taking Some Risk With Its 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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Huadian Power International Corporation Limited (HKG:1071) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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.

Check out our latest analysis for Huadian Power International

What Is Huadian Power International's Debt?

The chart below, which you can click on for greater detail, shows that Huadian Power International had CN¥116.6b in debt in September 2023; about the same as the year before. However, it also had CN¥7.37b in cash, and so its net debt is CN¥109.3b.

How Strong Is Huadian Power International's Balance Sheet?

We can see from the most recent balance sheet that Huadian Power International had liabilities of CN¥54.3b falling due within a year, and liabilities of CN¥82.4b due beyond that. Offsetting these obligations, it had cash of CN¥7.37b as well as receivables valued at CN¥13.5b due within 12 months. So its liabilities total CN¥115.9b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥58.4b 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. At the end of the day, Huadian Power International 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.

As it happens Huadian Power International has a fairly concerning net debt to EBITDA ratio of 10.0 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Notably, Huadian Power International made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥2.3b in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Huadian Power International can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Huadian Power International produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Huadian Power International's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Huadian Power International has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example Huadian Power International has 3 warning signs (and 2 which are significant) we think you should know about.

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. 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.