Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Guangdong Investment Limited (HKG:270) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Guangdong Investment

How Much Debt Does Guangdong Investment Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Guangdong Investment had HK$45.1b of debt, an increase on HK$41.0b, over one year. However, it also had HK$14.6b in cash, and so its net debt is HK$30.5b.

How Healthy Is Guangdong Investment's Balance Sheet?

We can see from the most recent balance sheet that Guangdong Investment had liabilities of HK$43.1b falling due within a year, and liabilities of HK$42.0b due beyond that. Offsetting these obligations, it had cash of HK$14.6b as well as receivables valued at HK$8.43b due within 12 months. So it has liabilities totalling HK$62.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$39.8b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Guangdong Investment would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt to EBITDA of 3.7 Guangdong Investment has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.7. Unfortunately, Guangdong Investment's EBIT flopped 19% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 Guangdong Investment'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Guangdong Investment 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.

Our View

To be frank both Guangdong Investment's EBIT growth rate and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Guangdong Investment is in the Water Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Guangdong Investment has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Guangdong Investment that you should be aware of.

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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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.