Towngas Smart Energy (HKG:1083) Has No Shortage Of Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Towngas Smart Energy Company Limited (HKG:1083) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out the opportunities and risks within the HK Gas Utilities industry.

What Is Towngas Smart Energy's Debt?

As you can see below, at the end of June 2022, Towngas Smart Energy had HK$19.0b of debt, up from HK$17.3b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$3.87b, its net debt is less, at about HK$15.1b.

How Strong Is Towngas Smart Energy's Balance Sheet?

We can see from the most recent balance sheet that Towngas Smart Energy had liabilities of HK$15.6b falling due within a year, and liabilities of HK$12.5b due beyond that. Offsetting these obligations, it had cash of HK$3.87b as well as receivables valued at HK$2.25b due within 12 months. So it has liabilities totalling HK$22.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$11.5b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Towngas Smart Energy would likely require a major re-capitalisation if it had to pay its creditors today.

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.

With a net debt to EBITDA ratio of 5.3, it's fair to say Towngas Smart Energy does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.1 times, suggesting it can responsibly service its obligations. Even more troubling is the fact that Towngas Smart Energy actually let its EBIT decrease by 3.4% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Towngas Smart Energy's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Towngas Smart Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Towngas Smart Energy's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that Towngas Smart Energy is in the Gas Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think Towngas Smart Energy has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 3 warning signs for Towngas Smart Energy (1 is significant!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.