David Iben put it well when he said, “Volatility is not a risk we care about. What matters to us is to avoid the permanent loss of capital. ‘ It is only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that Datang International Power Generation Co., Ltd. (HKG: 991) uses debt in his business. But should shareholders be concerned about its use of debt?
Why Does Debt Bring Risk?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
See our latest analysis for Datang International Power Generation
What is the debt of Datang International Power Generation?
The graph below, which you can click for more details, shows that Datang International Power Generation had CN 148.9 billion debt in June 2021; about the same as the year before. However, given that it has a cash reserve of CNN 9.86 billion, its net debt is lower, at around CNN 139.0 billion.
A look at the responsibilities of Datang International Power Generation
The latest balance sheet data shows Datang International Power Generation had CN 76.2 billion liabilities due within one year, and CN 113.4 billion liabilities due after that. In return, he had CN 9.86 billion in cash and CN 20.3 billion in receivables due within 12 months. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by 159.3b CN.
This deficit casts a shadow over the CN ¥ 43.4b company, like a colossus towering above mere mortals. We therefore believe that shareholders should watch it closely. Ultimately, Datang International Power Generation would likely need a major recapitalization if its creditors demanded repayment.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we look at debt over earnings with and without amortization charges.
Datang International Power Generation has a rather high debt to EBITDA ratio of 5.4, which suggests significant leverage. However, its interest coverage of 3.5 is reasonably strong, which is a good sign. Fortunately, Datang International Power Generation has increased its EBIT by 2.1% over the past year, slowly reducing its debt to earnings. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine Datang International Power Generation’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 business cannot pay its debts with paper profits; he needs hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Datang International Power Generation has recorded free cash flow totaling 83% of its EBIT, which is higher than what we usually expected. This puts him in a very strong position to pay off the debt.
Our point of view
To be frank, Datang International Power Generation’s net debt to EBITDA and track record of controlling total liabilities makes us rather uncomfortable with its debt levels. But on the positive side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. Overall, we think it’s fair to say that Datang International Power Generation has enough debt that there is real risk around the balance sheet. If all goes well, this should increase returns, but on the other hand, the risk of permanent capital loss is increased by debt. 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 off the balance sheet. To this end, you should inquire about the 3 warning signs we spotted with Datang International Power Generation (including 1 which is of concern).
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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