These 4 Measures Indicate That Beijing Enterprises Holdings (HKG:392) Is Using Debt Extensively

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Beijing Enterprises Holdings Limited (HKG:392) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Beijing Enterprises Holdings

What Is Beijing Enterprises Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Beijing Enterprises Holdings had HK$66.0b of debt, an increase on HK$62.3b, over one year. On the flip side, it has HK$26.1b in cash leading to net debt of about HK$39.9b.

How Strong Is Beijing Enterprises Holdings's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Beijing Enterprises Holdings had liabilities of HK$49.2b due within 12 months and liabilities of HK$52.2b due beyond that. Offsetting this, it had HK$26.1b in cash and HK$6.02b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$69.3b.

The deficiency here weighs heavily on the HK$31.9b 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. At the end of the day, Beijing Enterprises Holdings 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Beijing Enterprises Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (5.6), and fairly weak interest coverage, since EBIT is just 2.1 times the interest expense. The debt burden here is substantial. Even more troubling is the fact that Beijing Enterprises Holdings actually let its EBIT decrease by 5.7% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Beijing Enterprises Holdings's free cash flow amounted to 25% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Beijing Enterprises Holdings's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its conversion of EBIT to free cash flow fails to inspire much confidence. It's also worth noting that Beijing Enterprises Holdings is in the Gas Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think Beijing Enterprises Holdings has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Beijing Enterprises Holdings 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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