Guangdong Investment (HKG:270) Use Of Debt Could Be Considered Risky

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Guangdong Investment Limited (HKG:270) does carry debt. But the real question is whether this debt is making the company risky.

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Guangdong Investment

What Is Guangdong Investment's Debt?

As you can see below, at the end of December 2022, Guangdong Investment had HK$41.5b of debt, up from HK$30.1b a year ago. Click the image for more detail. However, it also had HK$8.94b in cash, and so its net debt is HK$32.6b.

A Look At Guangdong Investment's Liabilities

According to the last reported balance sheet, Guangdong Investment had liabilities of HK$35.7b due within 12 months, and liabilities of HK$39.3b due beyond 12 months. Offsetting this, it had HK$8.94b in cash and HK$6.98b in receivables that were due within 12 months. So it has liabilities totalling HK$59.1b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of HK$50.6b, we think shareholders really should watch Guangdong Investment's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Guangdong Investment's net debt is 4.0 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 10.7 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. The bad news is that Guangdong Investment saw its EBIT decline by 20% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Guangdong Investment's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by 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. Overall, it seems to us that Guangdong Investment'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. For instance, we've identified 1 warning sign for Guangdong Investment that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.