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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies China Everbright Environment Group Limited (HKG:257) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for China Everbright Environment Group
What Is China Everbright Environment Group's Net Debt?
The chart below, which you can click on for greater detail, shows that China Everbright Environment Group had HK$94.2b in debt in June 2024; about the same as the year before. However, it also had HK$8.23b in cash, and so its net debt is HK$85.9b.
How Healthy Is China Everbright Environment Group's Balance Sheet?
We can see from the most recent balance sheet that China Everbright Environment Group had liabilities of HK$34.4b falling due within a year, and liabilities of HK$87.3b due beyond that. Offsetting this, it had HK$8.23b in cash and HK$39.2b in receivables that were due within 12 months. So it has liabilities totalling HK$74.4b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$22.4b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Everbright Environment Group would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a net debt to EBITDA ratio of 6.9, it's fair to say China Everbright Environment Group does have a significant amount of debt. However, its interest coverage of 3.2 is reasonably strong, which is a good sign. More concerning, China Everbright Environment Group saw its EBIT drop by 5.7% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if China Everbright Environment Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. Considering the last three years, China Everbright Environment Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Our View
To be frank both China Everbright Environment Group's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like China Everbright Environment Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for China Everbright Environment Group (of which 1 is a bit unpleasant!) you should know about.
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.
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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.