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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Towngas Smart Energy Company Limited (HKG:1083) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Towngas Smart Energy

What Is Towngas Smart Energy's Debt?

The image below, which you can click on for greater detail, shows that at June 2023 Towngas Smart Energy had debt of HK$21.3b, up from HK$19.0b in one year. However, because it has a cash reserve of HK$4.25b, its net debt is less, at about HK$17.0b.

How Healthy Is Towngas Smart Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Towngas Smart Energy had liabilities of HK$16.6b due within 12 months and liabilities of HK$14.4b due beyond that. On the other hand, it had cash of HK$4.25b and HK$2.39b worth of receivables due within a year. So its liabilities total HK$24.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$10.9b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Towngas Smart Energy 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.

Towngas Smart Energy shareholders face the double whammy of a high net debt to EBITDA ratio (6.9), and fairly weak interest coverage, since EBIT is just 2.3 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, Towngas Smart Energy saw its EBIT tank 24% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. We should also note that Gas Utilities industry companies like Towngas Smart Energy commonly do use debt without problems. Considering everything we've mentioned above, it's fair to say that Towngas Smart Energy is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 5 warning signs for Towngas Smart Energy (1 is a bit unpleasant!) that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.