Does HK Electric Investments and HK Electric Investments (HKG:2638) 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.' 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. Importantly, HK Electric Investments and HK Electric Investments Limited (HKG:2638) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for HK Electric Investments and HK Electric Investments

What Is HK Electric Investments and HK Electric Investments's Debt?

As you can see below, at the end of June 2023, HK Electric Investments and HK Electric Investments had HK$52.1b of debt, up from HK$49.7b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

A Look At HK Electric Investments and HK Electric Investments' Liabilities

According to the last reported balance sheet, HK Electric Investments and HK Electric Investments had liabilities of HK$4.47b due within 12 months, and liabilities of HK$67.4b due beyond 12 months. Offsetting these obligations, it had cash of HK$393.0m as well as receivables valued at HK$2.26b due within 12 months. So its liabilities total HK$69.2b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$38.2b 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, HK Electric Investments and HK Electric Investments 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.

HK Electric Investments and HK Electric Investments has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. However, its interest coverage of 4.2 is reasonably strong, which is a good sign. Fortunately, HK Electric Investments and HK Electric Investments grew its EBIT by 6.8% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if HK Electric Investments and HK Electric Investments 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, HK Electric Investments and HK Electric Investments reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, HK Electric Investments and HK Electric Investments'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 EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Electric Utilities industry companies like HK Electric Investments and HK Electric Investments commonly do use debt without problems. We're quite clear that we consider HK Electric Investments and HK Electric Investments to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for HK Electric Investments and HK Electric Investments you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.