Is Hangzhou Cogeneration Group (SHSE:605011) Using Too Much Debt?

Simply Wall St · 10/15 07:26

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Hangzhou Cogeneration Group Co., Ltd. (SHSE:605011) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Hangzhou Cogeneration Group

What Is Hangzhou Cogeneration Group's Debt?

The image below, which you can click on for greater detail, shows that Hangzhou Cogeneration Group had debt of CN¥700.1m at the end of June 2024, a reduction from CN¥846.5m over a year. However, it also had CN¥668.6m in cash, and so its net debt is CN¥31.5m.

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SHSE:605011 Debt to Equity History October 15th 2024

How Healthy Is Hangzhou Cogeneration Group's Balance Sheet?

The latest balance sheet data shows that Hangzhou Cogeneration Group had liabilities of CN¥795.2m due within a year, and liabilities of CN¥367.0m falling due after that. On the other hand, it had cash of CN¥668.6m and CN¥417.2m worth of receivables due within a year. So its liabilities total CN¥76.3m more than the combination of its cash and short-term receivables.

This state of affairs indicates that Hangzhou Cogeneration Group's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CN¥8.84b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, Hangzhou Cogeneration Group has a very light debt load indeed.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Hangzhou Cogeneration Group has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.089. Happily, it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like an Olympic ice-skater handles a pirouette. The good news is that Hangzhou Cogeneration Group has increased its EBIT by 7.8% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hangzhou Cogeneration Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Hangzhou Cogeneration Group generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that Hangzhou Cogeneration Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. It's also worth noting that Hangzhou Cogeneration Group is in the Electric Utilities industry, which is often considered to be quite defensive. Considering this range of factors, it seems to us that Hangzhou Cogeneration Group is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Hangzhou Cogeneration Group you should be aware of, and 1 of them is a bit concerning.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.