Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” It’s 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 notice that ENN Energy Holdings Limited (HKG: 2688) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
When is Debt a Problem?
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. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
Check out our latest analysis for ENN Energy Holdings
What is the net debt of ENN Energy Holdings?
You can click on the graph below for historical figures, but it shows that ENN Energy Holdings had CN 18.3 billion in debt in June 2021, up from CNN 20.7 billion a year earlier. On the other hand, he has CNN 8.73 billion in cash, resulting in net debt of around CNN 9.54 billion.
How healthy is ENN Energy Holdings’ balance sheet?
According to the latest published balance sheet, ENN Energy Holdings had a liability of CN ¥ 34.2b due within 12 months and a liability of CN ¥ 19.7b due beyond 12 months. In return, he had CNS 8.73 billion in cash and CN 8.97 billion in receivables due within 12 months. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by CN ¥ 36.2b.
While that might sound like a lot, it’s not that bad as ENN Energy Holdings has a huge market cap of CN ¥ 127.0b, and so it could 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 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 earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
ENN Energy Holdings’ net debt is only 0.85 times its EBITDA. And its EBIT covers its interest costs 45.7 times more. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Also positive, ENN Energy Holdings has increased its EBIT by 28% over the past year, which should make it easier to repay debt going forward. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine ENN Energy Holdings’ ability to maintain a healthy balance sheet going forward. So, if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, ENN Energy Holdings has generated strong free cash flow equivalent to 57% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Fortunately, ENN Energy Holdings’ impressive interest coverage means it has the upper hand on its debt. And that’s just the start of good news as its EBIT growth rate is also very encouraging. It should also be noted that ENN Energy Holdings belongs to the gas utilities sector, which is often viewed as quite defensive. Looking at the big picture, we think ENN Energy Holdings’ use of debt looks very reasonable and we don’t care. After all, reasonable leverage can increase returns on equity. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for ENN Energy Holdings you should know.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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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 any stock 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 any of the stocks mentioned.