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.' 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. As with many other companies Beijing Energy International Holding Co., Ltd. (HKG:686) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Beijing Energy International Holding's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Beijing Energy International Holding had CN¥23.6b of debt, an increase on CN¥18.1b, over one year. On the flip side, it has CN¥5.00b in cash leading to net debt of about CN¥18.6b.
How Healthy Is Beijing Energy International Holding's Balance Sheet?
We can see from the most recent balance sheet that Beijing Energy International Holding had liabilities of CN¥10.4b falling due within a year, and liabilities of CN¥16.2b due beyond that. Offsetting this, it had CN¥5.00b in cash and CN¥8.80b in receivables that were due within 12 months. So it has liabilities totalling CN¥12.9b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥5.12b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Beijing Energy International Holding would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 9.3 hit our confidence in Beijing Energy International Holding like a one-two punch to the gut. The debt burden here is substantial. However, one redeeming factor is that Beijing Energy International Holding grew its EBIT at 11% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Beijing Energy International Holding's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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 Energy International Holding's free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Beijing Energy International Holding's interest cover 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. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Beijing Energy International Holding's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Beijing Energy International Holding (of which 1 is a bit concerning!) you should know about.
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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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.
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