David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that China Power Engineering Company Limited (HKG:3996) uses debt in his business. But should shareholders worry about its use of debt?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we look at debt levels, we first consider cash and debt levels, together.
See our latest analysis for China Energy Engineering
What is China Energy Engineering’s debt?
As you can see below, at the end of June 2022, China Energy Engineering had a debt of 153.5 billion Canadian yen, compared to 120.8 billion Canadian yen a year ago. Click on the image for more details. However, since it has a cash reserve of 57.1 billion Canadian yen, its net debt is less, at around 96.3 billion Canadian yen.
How strong is China Energy Engineering’s balance sheet?
According to the latest published balance sheet, China Energy Engineering had liabilities of 309.9 billion Canadian yen due within 12 months and liabilities of 126.1 billion Canadian yen due beyond 12 months. On the other hand, it had a cash position of 57.1 billion Canadian yen and 190.0 billion national yen of receivables due within the year. It therefore has liabilities totaling 188.8 billion Canadian yen more than its cash and short-term receivables, combined.
The deficiency here weighs heavily on the CN¥31.0b business itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet. We would therefore be watching his balance sheet closely, no doubt. Ultimately, China Energy Engineering would likely need a major recapitalization if its creditors demanded repayment.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (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 4.6, China Energy Engineering has a fairly notable amount of debt. But the high interest coverage of 7.4 suggests it can easily repay that debt. The bad news is that China Energy Engineering has seen its EBIT fall by 15% over the past year. If that kind of decline isn’t stopped, then managing his debt will be harder than selling broccoli-flavored ice cream for a bounty. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine China Energy Engineering’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, China Energy Engineering has had substantial negative free cash flow, overall. While investors no doubt expect a reversal of this situation in due course, it clearly means that its use of debt is more risky.
Our point of view
To be frank, China Energy Engineering’s conversion of EBIT to free cash flow and its track record of keeping its total liabilities under control makes us rather uncomfortable with its level of leverage. But on the bright side, its interest coverage is a good sign and makes us more optimistic. Considering all the above factors, it seems that China Energy Engineering is too much in debt. That kind of risk is acceptable to some, but it certainly doesn’t float our boat. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we have identified 2 warning signs for China Energy Engineering (1 doesn’t sit too well with us) you should know.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-flowing growth stocks without further ado.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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