Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Guangdong Investment Limited (HKG:270) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
See 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$45.6b of debt, an increase on HK$41.7b, over one year. However, it does have HK$14.6b in cash offsetting this, leading to net debt of about HK$31.0b.
How Healthy Is Guangdong Investment’s Balance Sheet?
The latest balance sheet data shows that Guangdong Investment had liabilities of HK$43.1b due within a year, and liabilities of HK$42.0b falling due after 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.
The deficiency here weighs heavily on the HK$35.0b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Guangdong Investment’s net debt is 3.8 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 10.1 times its interest expense, implying the company isn’t really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Unfortunately, Guangdong Investment saw its EBIT slide 6.0% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Guangdong Investment saw substantial negative free cash flow, in total. 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
On the face of it, Guangdong Investment’s conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at covering its interest expense with its EBIT; that’s encouraging. We should also note that Water Utilities industry companies like Guangdong Investment commonly do use debt without problems. Overall, it seems to us that Guangdong Investment’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. To that end, you should learn about the 2 warning signs we’ve spotted with Guangdong Investment (including 1 which is a bit unpleasant) .
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
Valuation is complex, but we’re helping make it simple.
Find out whether Guangdong Investment is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
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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.
