We Think Chongqing Sanfeng Environment Group (SHSE:601827) Is Taking Some Risk With Its Debt

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 Chongqing Sanfeng Environment Group Corp., Ltd. (SHSE:601827) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Chongqing Sanfeng Environment Group

What Is Chongqing Sanfeng Environment Group's Debt?

As you can see below, at the end of March 2024, Chongqing Sanfeng Environment Group had CN¥9.04b of debt, up from CN¥8.67b a year ago. Click the image for more detail. However, it does have CN¥2.71b in cash offsetting this, leading to net debt of about CN¥6.33b.

How Healthy Is Chongqing Sanfeng Environment Group's Balance Sheet?

The latest balance sheet data shows that Chongqing Sanfeng Environment Group had liabilities of CN¥5.74b due within a year, and liabilities of CN¥8.39b falling due after that. On the other hand, it had cash of CN¥2.71b and CN¥2.45b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.97b.

This is a mountain of leverage relative to its market capitalization of CN¥14.2b. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Chongqing Sanfeng Environment Group has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 6.2 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Chongqing Sanfeng Environment Group saw its EBIT slide 2.5% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Chongqing Sanfeng Environment Group can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Chongqing Sanfeng Environment Group recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Chongqing Sanfeng Environment Group's level of total liabilities makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at covering its interest expense with its EBIT. When we consider all the factors discussed, it seems to us that Chongqing Sanfeng Environment Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 2 warning signs for Chongqing Sanfeng Environment Group that you should be aware of.

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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