Here's Why HK Electric Investments and HK Electric Investments (HKG:2638) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that HK Electric Investments and HK Electric Investments Limited (HKG:2638) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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

How Much Debt Does HK Electric Investments and HK Electric Investments Carry?

The image below, which you can click on for greater detail, shows that at December 2020 HK Electric Investments and HK Electric Investments had debt of HK$44.9b, up from HK$43.0b in one year. Net debt is about the same, since the it doesn't have much cash.

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

Zooming in on the latest balance sheet data, we can see that HK Electric Investments and HK Electric Investments had liabilities of HK$8.34b due within 12 months and liabilities of HK$55.5b due beyond that. Offsetting these obligations, it had cash of HK$172.0m as well as receivables valued at HK$828.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$62.8b.

This deficit is considerable relative to its market capitalization of HK$69.5b, so it does suggest shareholders should keep an eye on HK Electric Investments and HK Electric Investments' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 net debt to EBITDA ratio of 6.2, it's fair to say HK Electric Investments and HK Electric Investments does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.2 times, suggesting it can responsibly service its obligations. Even more troubling is the fact that HK Electric Investments and HK Electric Investments actually let its EBIT decrease by 7.1% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, HK Electric Investments and HK Electric Investments's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say HK Electric Investments and HK Electric Investments's net debt to EBITDA was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. It's also worth noting that HK Electric Investments and HK Electric Investments is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that HK Electric Investments and HK Electric Investments's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. To that end, you should be aware of the 2 warning signs we've spotted with HK Electric Investments and HK Electric Investments .

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. 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.
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