Howard Marks put it nicely when he said that instead of worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about … and every practical investor I know is concerned about.” , worries.” So it seems that smart money knows that debt – which usually plays a role in bankruptcies – is a very important factor when assessing a company’s risk. We can see that Beijing Enterprises Water Group Limited (HKG:371) uses debt in his business. But should shareholders be concerned about the use of debt?
What is the risk of debt?
Debt helps a business until the business struggles to pay it back, either with new capital or free cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. A more common (but still costly) case, however, is when a company has to issue stock at bargain prices, which permanently dilutes shareholders, just to shore up its balance sheet. Of course, many companies use debt to fund growth, with no ill effects. When examining debt, let’s first look at both cash and debt together.
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What is the debt of Beijing Enterprises Water Group?
As you can see below, Beijing Enterprises Water Group had HK$83.0 billion in debt at the end of June 2022, up from HK$75.6 billion a year earlier. Click on the picture for more details. However, it also had HK$14.3 billion in cash, making its net debt HK$68.7 billion.
A look at Beijing Enterprises Water Group’s liabilities
The latest balance sheet shows that Beijing Enterprises Water Group had HK$54.9 billion in debt maturing within one year and HK$72.2 billion in debt maturing beyond it were. On the other hand, it had HK$14.3 billion in cash and HK$20.6 billion in receivables maturing within one year. Therefore, its liabilities exceed the sum of its cash and (short-term) receivables by HK$92.2 billion.
This shortage weighs heavily on the HK$18.4 billion company itself, like a child struggling under the weight of a huge backpack full of books, its sports gear and a trumpet. So we would no doubt be watching his record closely. After all, Beijing Enterprises Water Group would likely need a major recapitalization if it had to pay its creditors today.
To estimate a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its interest expense (its interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio).
With a net debt to EBITDA ratio of 8.9, it’s fair to say that Beijing Enterprises Water Group has significant debt. However, the rate coverage of 4.2 is quite strong, which is a good sign. More worryingly, Beijing Enterprises Water Group reported a 5.8% trailing 12-month EBIT decline. At this rate, paying off your debts will be like running on a treadmill—a lot of effort for little progress. Undoubtedly, we learn most about debt from the balance sheet. But ultimately, the company’s future profitability will determine whether Beijing Enterprises Water Group can strengthen its balance sheet over time. So if you focus on the future, you can check this free Analyst earnings forecast report.
Finally, while the helmsman may love book profits, lenders only accept cold, hard cash. So the logical step is to look at the proportion of that EBIT that corresponds to actual free cash flow. Over the past three years, Beijing Enterprises Water Group has reported significant negative free cash flow overall. While investors are no doubt expecting a reversal of this situation in due course, it clearly means that using debt is riskier.
To be honest, both Beijing Enterprises Water Group’s EBIT to free cash flow conversion and its track record of managing its overall debt make us quite uncomfortable given its level of debt. And even the EBIT growth rate inspires little confidence. We should also note that water utility companies like Beijing Enterprises Water Group usually use debt without any problems. Taking all of the above factors into account, it looks like Beijing Enterprises Water Group has too much debt. While some investors love this type of risky play, it’s certainly not our cup of tea. The balance sheet is clearly the area to focus on when analyzing debt. However, the entire investment risk is not on the balance sheet – far from it. For example, we have identified 3 warning signs for the Beijing Enterprises Water Group (1 is worrying) you should note.
Ultimately, sometimes it’s easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with no net debt 100% freeat the moment.
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