We Think Binhai Investment (HKG:2886) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Binhai Investment Company Limited (HKG:2886) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Binhai Investment

What Is Binhai Investment's Debt?

As you can see below, Binhai Investment had HK$2.36b of debt at December 2020, down from HK$2.57b a year prior. However, because it has a cash reserve of HK$589.8m, its net debt is less, at about HK$1.77b.

How Strong Is Binhai Investment's Balance Sheet?

The latest balance sheet data shows that Binhai Investment had liabilities of HK$3.83b due within a year, and liabilities of HK$1.26b falling due after that. Offsetting this, it had HK$589.8m in cash and HK$341.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$4.16b.

The deficiency here weighs heavily on the HK$2.03b 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. At the end of the day, Binhai Investment would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Binhai Investment's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On the other hand, Binhai Investment grew its EBIT by 23% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 Binhai 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, 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, Binhai Investment created free cash flow amounting to 9.3% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Binhai Investment's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Gas Utilities industry companies like Binhai Investment commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Binhai Investment's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example Binhai Investment has 4 warning signs (and 1 which can't be ignored) we think you should know about.

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. 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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