Here's Why Beijing Enterprises Water Group (HKG:371) Is Weighed Down By Its Debt Load

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Beijing Enterprises Water Group

What Is Beijing Enterprises Water Group's Debt?

As you can see below, at the end of June 2022, Beijing Enterprises Water Group had HK$83.0b of debt, up from HK$75.6b a year ago. Click the image for more detail. However, it also had HK$14.3b in cash, and so its net debt is HK$68.7b.

A Look At Beijing Enterprises Water Group's Liabilities

We can see from the most recent balance sheet that Beijing Enterprises Water Group had liabilities of HK$54.9b falling due within a year, and liabilities of HK$72.2b due beyond that. On the other hand, it had cash of HK$14.3b and HK$20.6b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$92.2b.

The deficiency here weighs heavily on the HK$18.4b 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).

With a net debt to EBITDA ratio of 8.9, it's fair to say Beijing Enterprises Water Group does have a significant amount of debt. However, its interest coverage of 4.2 is reasonably strong, which is a good sign. More concerning, Beijing Enterprises Water Group saw its EBIT drop by 5.8% in the last twelve months. 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. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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

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. And even its EBIT growth rate fails to inspire much confidence. We should also note that Water Utilities industry companies like Beijing Enterprises Water Group commonly do use debt without problems. Taking into account all the aforementioned factors, it looks like Beijing Enterprises Water Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Beijing Enterprises Water Group (1 is concerning) you should be aware of.

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.