These 4 Measures Indicate That Guangdong Investment (HKG:270) Is Using Debt Reasonably Well

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.' 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 Guangdong Investment Limited (HKG:270) does use debt in its business. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out 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 December 2020 Guangdong Investment had debt of HK$12.6b, up from HK$9.33b in one year. However, it does have HK$10.4b in cash offsetting this, leading to net debt of about HK$2.25b.

How Healthy Is Guangdong Investment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Guangdong Investment had liabilities of HK$19.8b due within 12 months and liabilities of HK$13.9b due beyond that. Offsetting these obligations, it had cash of HK$10.4b as well as receivables valued at HK$6.12b due within 12 months. So its liabilities total HK$17.2b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Guangdong Investment has a huge market capitalization of HK$78.7b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Guangdong Investment has a low debt to EBITDA ratio of only 0.24. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. Also positive, Guangdong Investment grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. 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're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Guangdong Investment produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Guangdong Investment's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. We would also note that Water Utilities industry companies like Guangdong Investment commonly do use debt without problems. Zooming out, Guangdong Investment seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Guangdong Investment you should be aware of.

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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