Here's Why Datang International Power Generation (HKG:991) Is Weighed Down By Its Debt Load

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Datang International Power Generation Co., Ltd. (HKG:991) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Datang International Power Generation

How Much Debt Does Datang International Power Generation Carry?

As you can see below, Datang International Power Generation had CN¥169.5b of debt at September 2023, down from CN¥178.6b a year prior. On the flip side, it has CN¥11.1b in cash leading to net debt of about CN¥158.4b.

A Look At Datang International Power Generation's Liabilities

We can see from the most recent balance sheet that Datang International Power Generation had liabilities of CN¥77.6b falling due within a year, and liabilities of CN¥129.9b due beyond that. On the other hand, it had cash of CN¥11.1b and CN¥19.9b worth of receivables due within a year. So it has liabilities totalling CN¥176.4b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥37.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Datang International Power Generation 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). 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).

Weak interest cover of 2.5 times and a disturbingly high net debt to EBITDA ratio of 8.1 hit our confidence in Datang International Power Generation like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Datang International Power Generation achieved a positive EBIT of CN¥6.5b in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Datang International Power Generation 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, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Datang International Power Generation burned a lot of cash. 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 Datang International Power Generation'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. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Datang International Power Generation 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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Datang International Power Generation 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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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.