These 4 Measures Indicate That CGN Power (HKG:1816) Is Using Debt Extensively

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. Importantly, CGN Power Co., Ltd. (HKG:1816) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for CGN Power

What Is CGN Power's Debt?

The image below, which you can click on for greater detail, shows that CGN Power had debt of CN¥201.9b at the end of September 2020, a reduction from CN¥222.1b over a year. On the flip side, it has CN¥12.9b in cash leading to net debt of about CN¥189.0b.

A Look At CGN Power's Liabilities

The latest balance sheet data shows that CGN Power had liabilities of CN¥66.9b due within a year, and liabilities of CN¥176.2b falling due after that. On the other hand, it had cash of CN¥12.9b and CN¥10.5b worth of receivables due within a year. So it has liabilities totalling CN¥219.8b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥126.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, CGN Power 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

CGN Power has a rather high debt to EBITDA ratio of 5.5 which suggests a meaningful debt load. However, its interest coverage of 3.4 is reasonably strong, which is a good sign. Notably, CGN Power's EBIT was pretty flat over the last year, which isn't ideal given the debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if CGN Power can strengthen its balance sheet over time. 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 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, CGN Power produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, CGN Power's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it's fair to say that CGN Power 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. 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. To that end, you should learn about the 2 warning signs we've spotted with CGN Power (including 1 which is makes us a bit uncomfortable) .

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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