These 4 Measures Indicate That HK Electric Investments and HK Electric Investments (HKG:2638) Is Using Debt Extensively

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies HK Electric Investments and HK Electric Investments Limited (HKG:2638) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at 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 Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 HK Electric Investments and HK Electric Investments had debt of HK$49.7b, up from HK$46.4b 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?

We can see from the most recent balance sheet that HK Electric Investments and HK Electric Investments had liabilities of HK$6.80b falling due within a year, and liabilities of HK$63.1b due beyond that. Offsetting this, it had HK$154.0m in cash and HK$1.66b in receivables that were due within 12 months. So it has liabilities totalling HK$68.1b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's HK$51.2b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

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. However, its interest coverage of 5.9 is reasonably strong, which is a good sign. HK Electric Investments and HK Electric Investments grew its EBIT by 2.5% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to 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, 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. Looking at the most recent three years, HK Electric Investments and HK Electric Investments recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, HK Electric Investments and HK Electric Investments's level of total liabilities left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least its interest cover 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. Overall, it seems to us that HK Electric Investments and HK Electric Investments's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Be aware that HK Electric Investments and HK Electric Investments is showing 2 warning signs in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.