Is Central Plains Environment ProtectionLtd (SZSE:000544) A Risky Investment?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Central Plains Environment Protection Co.,Ltd. (SZSE:000544) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Central Plains Environment ProtectionLtd

What Is Central Plains Environment ProtectionLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Central Plains Environment ProtectionLtd had CN¥22.4b of debt, an increase on CN¥15.9b, over one year. However, because it has a cash reserve of CN¥1.71b, its net debt is less, at about CN¥20.7b.

A Look At Central Plains Environment ProtectionLtd's Liabilities

We can see from the most recent balance sheet that Central Plains Environment ProtectionLtd had liabilities of CN¥5.55b falling due within a year, and liabilities of CN¥22.6b due beyond that. Offsetting this, it had CN¥1.71b in cash and CN¥5.00b in receivables that were due within 12 months. So it has liabilities totalling CN¥21.4b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥7.39b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Central Plains Environment ProtectionLtd would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 2.4 times and a disturbingly high net debt to EBITDA ratio of 9.3 hit our confidence in Central Plains Environment ProtectionLtd like a one-two punch to the gut. The debt burden here is substantial. Fortunately, Central Plains Environment ProtectionLtd grew its EBIT by 9.9% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Central Plains Environment ProtectionLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Central Plains Environment ProtectionLtd 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

To be frank both Central Plains Environment ProtectionLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Central Plains Environment ProtectionLtd is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.

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