Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies China Resources Power Holdings Company Limited (HKG:836) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for China Resources Power Holdings
What Is China Resources Power Holdings's Debt?
As you can see below, at the end of December 2021, China Resources Power Holdings had HK$134.7b of debt, up from HK$108.2b a year ago. Click the image for more detail. However, because it has a cash reserve of HK$7.93b, its net debt is less, at about HK$126.8b.SEHK:836 Debt to Equity History June 12th 2022
A Look At China Resources Power Holdings' Liabilities
Zooming in on the latest balance sheet data, we can see that China Resources Power Holdings had liabilities of HK$68.1b due within 12 months and liabilities of HK$112.2b due beyond that. Offsetting these obligations, it had cash of HK$7.93b as well as receivables valued at HK$36.6b due within 12 months. So its liabilities total HK$135.8b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$69.5b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Resources Power Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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).
China Resources Power Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (6.4), and fairly weak interest coverage, since EBIT is just 1.7 times the interest expense. The debt burden here is substantial. Worse, China Resources Power Holdings's EBIT was down 65% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 China Resources Power 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. Over the last three years, China Resources Power Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both China Resources Power Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. It looks to us like China Resources Power Holdings carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. 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. For example China Resources Power Holdings has 3 warning signs (and 1 which makes us a bit uncomfortable) we think 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.