We Think CECEP Environmental Protection (SZSE:300140) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that CECEP Environmental Protection Co., Ltd. (SZSE:300140) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for CECEP Environmental Protection

What Is CECEP Environmental Protection's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2024 CECEP Environmental Protection had debt of CN¥12.3b, up from CN¥9.97b in one year. However, it also had CN¥2.63b in cash, and so its net debt is CN¥9.63b.

A Look At CECEP Environmental Protection's Liabilities

According to the last reported balance sheet, CECEP Environmental Protection had liabilities of CN¥4.66b due within 12 months, and liabilities of CN¥12.3b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.63b as well as receivables valued at CN¥5.71b due within 12 months. So its liabilities total CN¥8.65b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because CECEP Environmental Protection is worth CN¥20.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

CECEP Environmental Protection's debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 3.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, CECEP Environmental Protection saw its EBIT drop by 4.3% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since CECEP Environmental Protection will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, CECEP Environmental Protection's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While CECEP Environmental Protection's net debt to EBITDA makes us cautious about it, its track record of covering its interest expense with its EBIT is no better. But its not so bad at converting EBIT to free cash flow. When we consider all the factors discussed, it seems to us that CECEP Environmental Protection is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 3 warning signs for CECEP Environmental Protection (1 is potentially serious!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.