Does Jiangxi Hongcheng EnvironmentLtd (SHSE:600461) Have A Healthy Balance Sheet?

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 Jiangxi Hongcheng Environment Co.,Ltd. (SHSE:600461) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 Jiangxi Hongcheng EnvironmentLtd

What Is Jiangxi Hongcheng EnvironmentLtd's Net Debt?

As you can see below, Jiangxi Hongcheng EnvironmentLtd had CN¥8.14b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥2.73b in cash offsetting this, leading to net debt of about CN¥5.41b.

A Look At Jiangxi Hongcheng EnvironmentLtd's Liabilities

According to the last reported balance sheet, Jiangxi Hongcheng EnvironmentLtd had liabilities of CN¥8.18b due within 12 months, and liabilities of CN¥6.18b due beyond 12 months. On the other hand, it had cash of CN¥2.73b and CN¥2.93b worth of receivables due within a year. So its liabilities total CN¥8.69b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥12.2b, so it does suggest shareholders should keep an eye on Jiangxi Hongcheng EnvironmentLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Jiangxi Hongcheng EnvironmentLtd's moderate net debt to EBITDA ratio ( being 1.9), indicates prudence when it comes to debt. And its commanding EBIT of 10.0 times its interest expense, implies the debt load is as light as a peacock feather. We saw Jiangxi Hongcheng EnvironmentLtd grow its EBIT by 2.7% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Jiangxi Hongcheng EnvironmentLtd's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Jiangxi Hongcheng EnvironmentLtd created free cash flow amounting to 13% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Jiangxi Hongcheng EnvironmentLtd's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. It's also worth noting that Jiangxi Hongcheng EnvironmentLtd is in the Water Utilities industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that Jiangxi Hongcheng EnvironmentLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Jiangxi Hongcheng EnvironmentLtd that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.