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Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. ” So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We note that CLP Holdings Limited (HKG: 2) has debt on its balance sheet. But the most important question is: what risk does this debt create?
What risk does debt entail?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider both liquidity and debt levels.
Check out our latest analysis for CLP Holdings
What is the debt of CLP Holdings?
As you can see below, CLP Holdings had HK $ 59.1 billion in debt, as of June 2021, which is roughly the same as the year before. You can click on the graph for more details. However, given that it has a cash reserve of HK $ 11.2 billion, its net debt is less, at around HK $ 47.9 billion.
A look at the liabilities of CLP Holdings
We can see from the most recent balance sheet that CLP Holdings had liabilities of HK $ 35.9 billion due within one year and liabilities of HK $ 73.3 billion due beyond. In return, he had HK $ 11.2 billion in cash and HK $ 16.4 billion in receivables due within 12 months. It therefore has liabilities totaling HK $ 81.6 billion more than its cash and short-term receivables combined.
While that might sound like a lot, it isn’t that big of a deal since CLP Holdings has a massive market cap of HK $ 199.1 billion, and could therefore likely strengthen its balance sheet by raising capital if needed. However, it is always worth taking a close look at your ability to repay your debt.
We measure a company’s debt load relative to its earning capacity 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 costs (interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
CLP Holdings’ net debt to EBITDA ratio of around 2.1 suggests moderate use of debt. And its imposing EBIT of 10.4 times its interest costs, means the debt load is as light as a peacock feather. Unfortunately, CLP Holdings has seen its EBIT drop 2.3% over the past twelve months. If incomes continue to decline, managing that debt will be difficult, like delivering hot soup on a unicycle. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future earnings, more than anything, that will determine CLP Holdings’ ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, CLP Holdings has recorded free cash flow of 68% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
The ability of CLP Holdings to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow has reinforced our ability to manage its debt. That said, its EBIT growth rate does make us somewhat aware of potential future risks to the balance sheet. We also note that electric utility companies like CLP Holdings generally use debt without a problem. Given this range of data points, we believe that CLP Holdings is well positioned to manage its debt levels. That said, the load is heavy enough that we recommend that any shareholder watch it closely. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. To do this, you need to know the 1 warning sign we spotted with CLP Holdings.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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