Guangdong Investment (HKG:270) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Guangdong Investment Limited (HKG:270) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for Guangdong Investment

What Is Guangdong Investment's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2023 Guangdong Investment had debt of HK$45.1b, up from HK$41.0b in one year. However, it also had HK$14.6b in cash, and so its net debt is HK$30.5b.

How Strong Is Guangdong Investment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangdong Investment had liabilities of HK$43.1b due within 12 months and liabilities of HK$42.0b due beyond that. Offsetting these obligations, it had cash of HK$14.6b as well as receivables valued at HK$8.43b due within 12 months. So it has liabilities totalling HK$62.1b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$39.8b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Guangdong Investment would likely require a major re-capitalisation if it had to pay its creditors today.

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

Guangdong Investment has net debt to EBITDA of 3.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.7. The bad news is that Guangdong Investment saw its EBIT decline by 19% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guangdong Investment 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Guangdong Investment burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Guangdong Investment's EBIT growth rate left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Guangdong Investment is in the Water Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Guangdong Investment has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example, we've discovered 2 warning signs for Guangdong Investment that you should be aware of before investing here.

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.