Is China Resources and EnvironmentLtd (SHSE:600217) Using Too Much 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.' 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. As with many other companies China Resources and Environment Co.,Ltd. (SHSE:600217) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for China Resources and EnvironmentLtd

What Is China Resources and EnvironmentLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 China Resources and EnvironmentLtd had CN¥4.19b of debt, an increase on CN¥3.54b, over one year. However, it also had CN¥901.2m in cash, and so its net debt is CN¥3.29b.

How Healthy Is China Resources and EnvironmentLtd's Balance Sheet?

We can see from the most recent balance sheet that China Resources and EnvironmentLtd had liabilities of CN¥4.05b falling due within a year, and liabilities of CN¥780.6m due beyond that. On the other hand, it had cash of CN¥901.2m and CN¥5.96b worth of receivables due within a year. So it can boast CN¥2.02b more liquid assets than total liabilities.

This surplus suggests that China Resources and EnvironmentLtd is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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.

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 15.0 hit our confidence in China Resources and EnvironmentLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, China Resources and EnvironmentLtd saw its EBIT tank 50% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Resources and EnvironmentLtd's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Resources and EnvironmentLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both China Resources and EnvironmentLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Overall, we think it's fair to say that China Resources and EnvironmentLtd 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that China Resources and EnvironmentLtd is showing 5 warning signs in our investment analysis , and 2 of those don't sit too well with us...

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.