HK Electric Investments and HK Electric Investments (HKG:2638) Takes On Some Risk With Its Use Of Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies HK Electric Investments and HK Electric Investments Limited (HKG:2638) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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. 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?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 HK Electric Investments and HK Electric Investments had HK$49.7b of debt, an increase on HK$46.4b, over one year. 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$6.80b due within 12 months, and liabilities of HK$63.1b due beyond 12 months. On the other hand, it had cash of HK$154.0m and HK$1.66b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$68.1b.

Given this deficit is actually higher than the company's market capitalization of HK$63.2b, we think shareholders really should watch HK Electric Investments and HK Electric Investments's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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).

HK Electric Investments and HK Electric Investments has a rather high debt to EBITDA ratio of 6.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.9 times, suggesting it can responsibly service its obligations. We saw HK Electric Investments and HK Electric Investments grow its EBIT by 2.5% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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. In the last three years, HK Electric Investments and HK Electric Investments's free cash flow amounted to 32% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

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 interest cover is not so bad. We should also note that Electric Utilities industry companies like HK Electric Investments and HK Electric Investments commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making HK Electric Investments and HK Electric Investments stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. 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. 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.