We Think Xinyi Energy Holdings (HKG:3868) Is Taking Some Risk With Its Debt

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. Importantly, Xinyi Energy Holdings Limited (HKG:3868) does carry debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Xinyi Energy Holdings

How Much Debt Does Xinyi Energy Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Xinyi Energy Holdings had HK$5.22b of debt, an increase on HK$4.24b, over one year. However, because it has a cash reserve of HK$833.5m, its net debt is less, at about HK$4.39b.

How Strong Is Xinyi Energy Holdings' Balance Sheet?

According to the last reported balance sheet, Xinyi Energy Holdings had liabilities of HK$4.97b due within 12 months, and liabilities of HK$2.59b due beyond 12 months. On the other hand, it had cash of HK$833.5m and HK$4.12b worth of receivables due within a year. So its liabilities total HK$2.61b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Xinyi Energy Holdings is worth HK$12.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Xinyi Energy Holdings's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 4.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. The bad news is that Xinyi Energy Holdings saw its EBIT decline by 11% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Xinyi Energy Holdings'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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Xinyi Energy Holdings created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

While Xinyi Energy Holdings's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. At least its level of total liabilities gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Xinyi Energy Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 2 warning signs for Xinyi Energy Holdings you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.