Does CLP Holdings (HKG:2) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies CLP Holdings Limited (HKG:2) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for CLP Holdings

What Is CLP Holdings's Debt?

The image below, which you can click on for greater detail, shows that CLP Holdings had debt of HK$62.1b at the end of June 2023, a reduction from HK$65.0b over a year. However, because it has a cash reserve of HK$5.96b, its net debt is less, at about HK$56.1b.

A Look At CLP Holdings' Liabilities

The latest balance sheet data shows that CLP Holdings had liabilities of HK$43.7b due within a year, and liabilities of HK$75.6b falling due after that. On the other hand, it had cash of HK$5.96b and HK$15.3b worth of receivables due within a year. So its liabilities total HK$98.0b more than the combination of its cash and short-term receivables.

This is a mountain of leverage even relative to its gargantuan market capitalization of HK$147.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

CLP Holdings's net debt to EBITDA ratio of about 2.2 suggests only moderate use of debt. And its commanding EBIT of 11.4 times its interest expense, implies the debt load is as light as a peacock feather. We also note that CLP Holdings improved its EBIT from a last year's loss to a positive HK$17b. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine CLP Holdings'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. In the last year, CLP Holdings's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for CLP Holdings was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. It's also worth noting that CLP Holdings is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about CLP Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with CLP Holdings , and understanding them should be part of your investment process.

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.

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.