Does Central Plains Environment ProtectionLtd (SZSE:000544) Have A Healthy Balance Sheet?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Central Plains Environment Protection Co.,Ltd. (SZSE:000544) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Central Plains Environment ProtectionLtd

What Is Central Plains Environment ProtectionLtd's Debt?

As you can see below, at the end of September 2024, Central Plains Environment ProtectionLtd had CN¥22.7b of debt, up from CN¥19.1b a year ago. Click the image for more detail. However, it does have CN¥1.43b in cash offsetting this, leading to net debt of about CN¥21.3b.

How Healthy Is Central Plains Environment ProtectionLtd's Balance Sheet?

We can see from the most recent balance sheet that Central Plains Environment ProtectionLtd had liabilities of CN¥6.82b falling due within a year, and liabilities of CN¥21.6b due beyond that. Offsetting these obligations, it had cash of CN¥1.43b as well as receivables valued at CN¥7.44b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥19.5b.

This deficit casts a shadow over the CN¥8.81b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Central Plains Environment ProtectionLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Central Plains Environment ProtectionLtd shareholders face the double whammy of a high net debt to EBITDA ratio (10.0), and fairly weak interest coverage, since EBIT is just 2.4 times the interest expense. The debt burden here is substantial. Even more troubling is the fact that Central Plains Environment ProtectionLtd actually let its EBIT decrease by 2.7% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 Central Plains Environment ProtectionLtd 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Central Plains Environment ProtectionLtd saw substantial negative free cash flow, in total. 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

On the face of it, Central Plains Environment ProtectionLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Central Plains Environment ProtectionLtd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Be aware that Central Plains Environment ProtectionLtd is showing 2 warning signs in our investment analysis , and 1 of those is a bit concerning...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.