Here's Why HK Electric Investments and HK Electric Investments (HKG:2638) Is Weighed Down By Its Debt Load

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 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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

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

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

The image below, which you can click on for greater detail, shows that at December 2022 HK Electric Investments and HK Electric Investments had debt of HK$51.2b, up from HK$46.6b in one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is HK Electric Investments and HK Electric Investments' Balance Sheet?

The latest balance sheet data shows that HK Electric Investments and HK Electric Investments had liabilities of HK$5.53b due within a year, and liabilities of HK$66.1b falling due after that. On the other hand, it had cash of HK$415.0m and HK$1.54b worth of receivables due within a year. So its liabilities total HK$69.7b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$44.7b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. 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.

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 6.5, 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 4.8 times, suggesting it can responsibly service its obligations. Unfortunately, HK Electric Investments and HK Electric Investments saw its EBIT slide 9.6% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine HK Electric Investments and HK Electric Investments'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, HK Electric Investments and HK Electric Investments created free cash flow amounting to 19% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both HK Electric Investments and HK Electric Investments's level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We should also note that Electric Utilities industry companies like HK Electric Investments and HK Electric Investments commonly do use debt without problems. After considering the datapoints discussed, we think HK Electric Investments and HK Electric Investments has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that HK Electric Investments and HK Electric Investments is showing 2 warning signs in our investment analysis , 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.