Does Chongqing Water GroupLtd (SHSE:601158) 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.' 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. As with many other companies Chongqing Water Group Co.,Ltd. (SHSE:601158) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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.

View our latest analysis for Chongqing Water GroupLtd

How Much Debt Does Chongqing Water GroupLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Chongqing Water GroupLtd had debt of CN¥10.6b, up from CN¥8.62b in one year. However, because it has a cash reserve of CN¥1.43b, its net debt is less, at about CN¥9.19b.

How Strong Is Chongqing Water GroupLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chongqing Water GroupLtd had liabilities of CN¥8.04b due within 12 months and liabilities of CN¥8.82b due beyond that. Offsetting this, it had CN¥1.43b in cash and CN¥2.74b in receivables that were due within 12 months. So its liabilities total CN¥12.7b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Chongqing Water GroupLtd has a market capitalization of CN¥22.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Chongqing Water GroupLtd has a debt to EBITDA ratio of 4.2, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Shareholders should be aware that Chongqing Water GroupLtd's EBIT was down 87% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Chongqing Water GroupLtd 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Chongqing Water GroupLtd 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, Chongqing Water GroupLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like Chongqing Water GroupLtd commonly do use debt without problems. Overall, we think it's fair to say that Chongqing Water GroupLtd has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Case in point: We've spotted 4 warning signs for Chongqing Water GroupLtd you should be aware of, and 2 of them are a bit concerning.

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.