Here's Why ENN Energy Holdings (HKG:2688) Can Manage Its Debt Responsibly

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 ENN Energy Holdings Limited (HKG:2688) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out the opportunities and risks within the HK Gas Utilities industry.

What Is ENN Energy Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 ENN Energy Holdings had debt of CN¥22.7b, up from CN¥18.3b in one year. However, it also had CN¥12.0b in cash, and so its net debt is CN¥10.7b.

How Strong Is ENN Energy Holdings' Balance Sheet?

We can see from the most recent balance sheet that ENN Energy Holdings had liabilities of CN¥39.1b falling due within a year, and liabilities of CN¥20.9b due beyond that. Offsetting these obligations, it had cash of CN¥12.0b as well as receivables valued at CN¥9.96b due within 12 months. So its liabilities total CN¥38.0b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since ENN Energy Holdings has a huge market capitalization of CN¥113.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

ENN Energy Holdings's net debt is only 0.97 times its EBITDA. And its EBIT covers its interest expense a whopping 33.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, ENN Energy Holdings saw its EBIT drop by 4.9% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 ENN Energy Holdings 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, ENN Energy Holdings recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis ENN Energy Holdings's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its EBIT growth rate makes us a little nervous about its debt. It's also worth noting that ENN Energy Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. Considering this range of data points, we think ENN Energy Holdings is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that ENN Energy Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.