CECEP Environmental Protection (SZSE:300140) Takes On Some Risk With Its Use Of Debt

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies CECEP Environmental Protection Co., Ltd. (SZSE:300140) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for CECEP Environmental Protection

What Is CECEP Environmental Protection's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 CECEP Environmental Protection had CN¥8.89b of debt, an increase on CN¥276.5m, over one year. On the flip side, it has CN¥2.48b in cash leading to net debt of about CN¥6.41b.

How Strong Is CECEP Environmental Protection's Balance Sheet?

The latest balance sheet data shows that CECEP Environmental Protection had liabilities of CN¥4.70b due within a year, and liabilities of CN¥12.8b falling due after that. Offsetting these obligations, it had cash of CN¥2.48b as well as receivables valued at CN¥5.37b due within 12 months. So it has liabilities totalling CN¥9.67b more than its cash and near-term receivables, combined.

This deficit isn't so bad because CECEP Environmental Protection is worth CN¥21.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

CECEP Environmental Protection's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 2.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, CECEP Environmental Protection's EBIT fell a jaw-dropping 20% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is CECEP Environmental Protection's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent two years, CECEP Environmental Protection recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over CECEP Environmental Protection's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least its level of total liabilities is not so bad. Overall, we think it's fair to say that CECEP Environmental Protection has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with CECEP Environmental Protection , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.