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.' 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. We can see that Chongqing Sanfeng Environment Group Corp., Ltd. (SHSE:601827) does use debt in its business. 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. 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, 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.

See our latest analysis for Chongqing Sanfeng Environment Group

What Is Chongqing Sanfeng Environment Group's Debt?

As you can see below, Chongqing Sanfeng Environment Group had CN¥7.87b of debt at September 2024, down from CN¥8.65b a year prior. However, it does have CN¥1.30b in cash offsetting this, leading to net debt of about CN¥6.57b.

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

We can see from the most recent balance sheet that Chongqing Sanfeng Environment Group had liabilities of CN¥5.53b falling due within a year, and liabilities of CN¥7.29b due beyond that. Offsetting this, it had CN¥1.30b in cash and CN¥2.83b in receivables that were due within 12 months. So it has liabilities totalling CN¥8.69b more than its cash and near-term receivables, combined.

Chongqing Sanfeng Environment Group has a market capitalization of CN¥14.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chongqing Sanfeng Environment Group's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 6.0 times over. 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 9.4% 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Chongqing Sanfeng Environment Group's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Chongqing Sanfeng Environment Group's EBIT growth rate and its level of total liabilities were discouraging. At least its interest cover gives us reason to be optimistic. Taking the abovementioned factors together we do think Chongqing Sanfeng Environment Group's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 1 warning sign 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.