Beijing Enterprises Water Group (HKG:371) Seems To Be Using A Lot Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Beijing Enterprises Water Group Limited (HKG:371) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Beijing Enterprises Water Group

What Is Beijing Enterprises Water Group's Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Beijing Enterprises Water Group had debt of HK$75.6b, up from HK$64.7b in one year. However, because it has a cash reserve of HK$14.9b, its net debt is less, at about HK$60.6b.

How Healthy Is Beijing Enterprises Water Group's Balance Sheet?

According to the last reported balance sheet, Beijing Enterprises Water Group had liabilities of HK$47.9b due within 12 months, and liabilities of HK$72.7b due beyond 12 months. Offsetting these obligations, it had cash of HK$14.9b as well as receivables valued at HK$16.0b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$89.6b.

This deficit casts a shadow over the HK$34.6b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Beijing Enterprises Water Group would likely require a major re-capitalisation if it had to pay its creditors today.

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

With a net debt to EBITDA ratio of 7.7, it's fair to say Beijing Enterprises Water Group does have a significant amount of debt. However, its interest coverage of 4.6 is reasonably strong, which is a good sign. Sadly, Beijing Enterprises Water Group's EBIT actually dropped 7.9% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Beijing Enterprises Water Group's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Beijing Enterprises Water Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Beijing Enterprises Water Group's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its interest cover is not so bad. We should also note that Water Utilities industry companies like Beijing Enterprises Water Group commonly do use debt without problems. After considering the datapoints discussed, we think Beijing Enterprises Water Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Beijing Enterprises Water Group that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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