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

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.' 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. We can see that Beijing Enterprises Water Group Limited (HKG:371) does use debt in its business. 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. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Beijing Enterprises Water Group

What Is Beijing Enterprises Water Group's Net Debt?

As you can see below, at the end of December 2022, Beijing Enterprises Water Group had HK$82.1b of debt, up from HK$76.2b a year ago. Click the image for more detail. However, it also had HK$13.2b in cash, and so its net debt is HK$68.9b.

A Look At Beijing Enterprises Water Group's Liabilities

The latest balance sheet data shows that Beijing Enterprises Water Group had liabilities of HK$50.7b due within a year, and liabilities of HK$73.7b falling due after that. Offsetting these obligations, it had cash of HK$13.2b as well as receivables valued at HK$23.2b due within 12 months. So its liabilities total HK$88.1b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$19.3b 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 definitely think shareholders need to watch this one closely. At the end of the day, Beijing Enterprises Water Group would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

Beijing Enterprises Water Group has a rather high debt to EBITDA ratio of 11.7 which suggests a meaningful debt load. However, its interest coverage of 2.5 is reasonably strong, which is a good sign. Even worse, Beijing Enterprises Water Group saw its EBIT tank 33% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Beijing Enterprises Water Group 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 company can only pay off debt with cold hard cash, not accounting profits. 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 that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Beijing Enterprises Water Group's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. We should also note that Water Utilities industry companies like Beijing Enterprises Water Group commonly do use debt without problems. It looks to us like Beijing Enterprises Water Group carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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. Case in point: We've spotted 3 warning signs for Beijing Enterprises Water Group you should be aware of, and 1 of them is potentially serious.

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.