Does Chengdu Xingrong Environment (SZSE:000598) 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. Importantly, Chengdu Xingrong Environment Co., Ltd. (SZSE:000598) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Chengdu Xingrong Environment

How Much Debt Does Chengdu Xingrong Environment Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Chengdu Xingrong Environment had CN¥17.3b of debt, an increase on CN¥14.2b, over one year. However, it does have CN¥3.46b in cash offsetting this, leading to net debt of about CN¥13.8b.

A Look At Chengdu Xingrong Environment's Liabilities

Zooming in on the latest balance sheet data, we can see that Chengdu Xingrong Environment had liabilities of CN¥8.66b due within 12 months and liabilities of CN¥18.3b due beyond that. Offsetting this, it had CN¥3.46b in cash and CN¥3.70b in receivables that were due within 12 months. So its liabilities total CN¥19.8b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥19.9b, so it does suggest shareholders should keep an eye on Chengdu Xingrong Environment's use of debt. 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). 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).

Chengdu Xingrong Environment has net debt to EBITDA of 3.5 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.5. One way Chengdu Xingrong Environment could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 17%, as it did over the last year. 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 Chengdu Xingrong Environment'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.

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. Over the last three years, Chengdu Xingrong Environment 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

Mulling over Chengdu Xingrong Environment's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It's also worth noting that Chengdu Xingrong Environment is in the Water Utilities industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Chengdu Xingrong Environment stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Chengdu Xingrong Environment you should know about.

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.