We Think CLP Holdings (HKG:2) Can Stay On Top Of Its 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. Importantly, CLP Holdings Limited (HKG:2) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for CLP Holdings

How Much Debt Does CLP Holdings Carry?

The chart below, which you can click on for greater detail, shows that CLP Holdings had HK$58.1b in debt in December 2023; about the same as the year before. However, because it has a cash reserve of HK$8.04b, its net debt is less, at about HK$50.1b.

How Healthy Is CLP Holdings' Balance Sheet?

According to the last reported balance sheet, CLP Holdings had liabilities of HK$42.5b due within 12 months, and liabilities of HK$74.2b due beyond 12 months. Offsetting this, it had HK$8.04b in cash and HK$12.0b in receivables that were due within 12 months. So it has liabilities totalling HK$96.7b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of HK$157.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a debt to EBITDA ratio of 2.1, CLP Holdings uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.7 times interest expense) certainly does not do anything to dispel this impression. Notably, CLP Holdings's EBIT launched higher than Elon Musk, gaining a whopping 187% on last year. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, CLP Holdings recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis CLP Holdings's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. We would also note that Electric Utilities industry companies like CLP Holdings commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that CLP Holdings is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for CLP Holdings that you should be aware of before investing here.

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.

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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.