Is HK Electric Investments and HK Electric Investments (HKG:2638) A Risky Investment?

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 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?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for HK Electric Investments and HK Electric Investments

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

As you can see below, HK Electric Investments and HK Electric Investments had HK$46.6b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater 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

Zooming in on the latest balance sheet data, we can see that HK Electric Investments and HK Electric Investments had liabilities of HK$5.82b due within 12 months and liabilities of HK$60.6b due beyond that. Offsetting these obligations, it had cash of HK$119.0m as well as receivables valued at HK$1.07b due within 12 months. So its liabilities total HK$65.2b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$69.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

HK Electric Investments and HK Electric Investments has a rather high debt to EBITDA ratio of 5.6 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 6.3 times, suggesting it can responsibly service its obligations. If HK Electric Investments and HK Electric Investments can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, HK Electric Investments and HK Electric Investments recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

HK Electric Investments and HK Electric Investments's net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its EBIT growth rate was refreshing. 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. When we consider all the factors discussed, it seems to us that HK Electric Investments and HK Electric Investments is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 2 warning signs for HK Electric Investments and HK Electric Investments you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.