Huaneng Power International (HKG:902) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Huaneng Power International, Inc. (HKG:902) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Huaneng Power International

How Much Debt Does Huaneng Power International Carry?

You can click the graphic below for the historical numbers, but it shows that Huaneng Power International had CN¥228.5b of debt in September 2020, down from CN¥249.7b, one year before. On the flip side, it has CN¥14.0b in cash leading to net debt of about CN¥214.4b.

How Healthy Is Huaneng Power International's Balance Sheet?

According to the last reported balance sheet, Huaneng Power International had liabilities of CN¥135.7b due within 12 months, and liabilities of CN¥143.8b due beyond 12 months. On the other hand, it had cash of CN¥14.0b and CN¥37.2b worth of receivables due within a year. So it has liabilities totalling CN¥228.3b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥60.5b 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 definitely think shareholders need to watch this one closely. At the end of the day, Huaneng Power International would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Huaneng Power International has a debt to EBITDA ratio of 5.0 and its EBIT covered its interest expense 3.2 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Looking on the bright side, Huaneng Power International boosted its EBIT by a silky 30% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 Huaneng Power International's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Huaneng Power International'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

Mulling over Huaneng Power International's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Huaneng Power International has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. To that end, you should learn about the 3 warning signs we've spotted with Huaneng Power International (including 1 which is potentially serious) .

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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