Beijing Enterprises Water Group (HKG:371) Use Of Debt Could Be Considered Risky

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 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 and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Beijing Enterprises Water Group

How Much Debt Does Beijing Enterprises Water Group Carry?

As you can see below, at the end of June 2020, Beijing Enterprises Water Group had HK$64.7b of debt, up from HK$57.9b a year ago. Click the image for more detail. On the flip side, it has HK$10.8b in cash leading to net debt of about HK$53.9b.

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

Zooming in on the latest balance sheet data, we can see that Beijing Enterprises Water Group had liabilities of HK$46.6b due within 12 months and liabilities of HK$58.8b due beyond that. Offsetting this, it had HK$10.8b in cash and HK$12.0b in receivables that were due within 12 months. So its liabilities total HK$82.5b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$30.9b 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. 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). 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 6.4 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.3 times, suggesting it can responsibly service its obligations. Even more troubling is the fact that Beijing Enterprises Water Group actually let its EBIT decrease by 2.1% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, Beijing Enterprises Water Group saw substantial negative free cash flow, in total. 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

On the face of it, Beijing Enterprises Water Group's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that Beijing Enterprises Water Group is in the Water Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Beijing Enterprises Water Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Beijing Enterprises Water Group (1 is a bit unpleasant) 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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