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. As with many other companies HK Electric Investments and HK Electric Investments Limited (HKG:2638) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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, 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.

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

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

The chart below, which you can click on for greater detail, shows that HK Electric Investments and HK Electric Investments had HK$46.4b in debt in June 2021; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.

A Look At HK Electric Investments and HK Electric Investments' Liabilities

We can see from the most recent balance sheet that HK Electric Investments and HK Electric Investments had liabilities of HK$7.07b falling due within a year, and liabilities of HK$57.9b due beyond that. Offsetting this, it had HK$129.0m in cash and HK$1.41b in receivables that were due within 12 months. So it has liabilities totalling HK$63.4b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$67.6b, so it does suggest shareholders should keep an eye on HK Electric Investments and HK Electric Investments' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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 5.9 which suggests a meaningful debt load. However, its interest coverage of 5.3 is reasonably strong, which is a good sign. HK Electric Investments and HK Electric Investments grew its EBIT by 7.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, HK Electric Investments and HK Electric Investments's free cash flow amounted to 34% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over HK Electric Investments and HK Electric Investments's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. 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. 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. 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...

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.
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