We Think HK Electric Investments and HK Electric Investments (HKG:2638) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. 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?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. 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 Debt?

As you can see below, at the end of June 2020, HK Electric Investments and HK Electric Investments had HK$45.4b of debt, up from HK$43.5b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

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

The latest balance sheet data shows that HK Electric Investments and HK Electric Investments had liabilities of HK$23.0b due within a year, and liabilities of HK$40.2b falling due after that. Offsetting this, it had HK$802.0m in cash and HK$1.46b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$61.0b.

This is a mountain of leverage relative to its market capitalization of HK$68.1b. 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). 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 6.0 which suggests a meaningful debt load. However, its interest coverage of 4.3 is reasonably strong, which is a good sign. More concerning, HK Electric Investments and HK Electric Investments saw its EBIT drop by 7.9% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its 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'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's free cash flow amounted to 42% 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. 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 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. 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. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for HK Electric Investments and HK Electric Investments 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. 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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