Here's Why Guangdong Shenling Environmental Systems (SZSE:301018) Has A Meaningful Debt Burden

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.' 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 note that Guangdong Shenling Environmental Systems Co., Ltd. (SZSE:301018) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Guangdong Shenling Environmental Systems

How Much Debt Does Guangdong Shenling Environmental Systems Carry?

The image below, which you can click on for greater detail, shows that Guangdong Shenling Environmental Systems had debt of CN¥718.2m at the end of September 2024, a reduction from CN¥815.1m over a year. However, because it has a cash reserve of CN¥703.5m, its net debt is less, at about CN¥14.7m.

A Look At Guangdong Shenling Environmental Systems' Liabilities

The latest balance sheet data shows that Guangdong Shenling Environmental Systems had liabilities of CN¥2.00b due within a year, and liabilities of CN¥633.7m falling due after that. On the other hand, it had cash of CN¥703.5m and CN¥1.89b worth of receivables due within a year. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

Having regard to Guangdong Shenling Environmental Systems' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥8.55b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Guangdong Shenling Environmental Systems has a very light debt load indeed.

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.

Guangdong Shenling Environmental Systems has very modest net debt, giving rise to a debt to EBITDA ratio of 0.095. And this impression is enhanced by its strong EBIT which covers interest costs 9.7 times. It is just as well that Guangdong Shenling Environmental Systems's load is not too heavy, because its EBIT was down 58% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Guangdong Shenling Environmental Systems 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Guangdong Shenling Environmental Systems burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Guangdong Shenling Environmental Systems's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think Guangdong Shenling Environmental Systems's debt poses some risks to the business. 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. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Guangdong Shenling Environmental Systems that you should be aware of.

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.