Is Zhejiang Weiming Environment Protection (SHSE:603568) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, Zhejiang Weiming Environment Protection Co., Ltd. (SHSE:603568) does carry debt. But the real question is whether this debt is making the company risky.

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 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, 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 Zhejiang Weiming Environment Protection

What Is Zhejiang Weiming Environment Protection's Debt?

The chart below, which you can click on for greater detail, shows that Zhejiang Weiming Environment Protection had CN¥6.10b in debt in September 2023; about the same as the year before. However, because it has a cash reserve of CN¥2.07b, its net debt is less, at about CN¥4.03b.

How Healthy Is Zhejiang Weiming Environment Protection's Balance Sheet?

According to the last reported balance sheet, Zhejiang Weiming Environment Protection had liabilities of CN¥3.40b due within 12 months, and liabilities of CN¥7.42b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.07b as well as receivables valued at CN¥2.82b due within 12 months. So its liabilities total CN¥5.93b more than the combination of its cash and short-term receivables.

Of course, Zhejiang Weiming Environment Protection has a market capitalization of CN¥32.2b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Zhejiang Weiming Environment Protection's net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 71.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Zhejiang Weiming Environment Protection has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zhejiang Weiming Environment Protection can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Zhejiang Weiming Environment Protection 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

Based on what we've seen Zhejiang Weiming Environment Protection is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Considering this range of data points, we think Zhejiang Weiming Environment Protection is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Zhejiang Weiming Environment Protection is showing 1 warning sign in our investment analysis , you should know about...

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.