Here's Why Jiangxi Hongcheng EnvironmentLtd (SHSE:600461) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Jiangxi Hongcheng Environment Co.,Ltd. (SHSE:600461) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Jiangxi Hongcheng EnvironmentLtd

What Is Jiangxi Hongcheng EnvironmentLtd's Net Debt?

As you can see below, at the end of March 2024, Jiangxi Hongcheng EnvironmentLtd had CN¥7.73b of debt, up from CN¥7.37b a year ago. Click the image for more detail. However, it does have CN¥2.43b in cash offsetting this, leading to net debt of about CN¥5.30b.

A Look At Jiangxi Hongcheng EnvironmentLtd's Liabilities

We can see from the most recent balance sheet that Jiangxi Hongcheng EnvironmentLtd had liabilities of CN¥8.43b falling due within a year, and liabilities of CN¥5.54b due beyond that. On the other hand, it had cash of CN¥2.43b and CN¥2.67b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.87b.

This is a mountain of leverage relative to its market capitalization of CN¥14.0b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

With a debt to EBITDA ratio of 1.9, Jiangxi Hongcheng EnvironmentLtd uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.1 times its interest expenses harmonizes with that theme. If Jiangxi Hongcheng EnvironmentLtd can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is Jiangxi Hongcheng EnvironmentLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Jiangxi Hongcheng EnvironmentLtd created free cash flow amounting to 3.4% 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 struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. We should also note that Water Utilities industry companies like Jiangxi Hongcheng EnvironmentLtd commonly do use debt without problems. We think that Jiangxi Hongcheng EnvironmentLtd's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Jiangxi Hongcheng EnvironmentLtd has 3 warning signs we think you should be aware of.

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.