Is Chengdu Xingrong Environment (SZSE:000598) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Chengdu Xingrong Environment Co., Ltd. (SZSE:000598) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Chengdu Xingrong Environment

How Much Debt Does Chengdu Xingrong Environment Carry?

The image below, which you can click on for greater detail, shows that at September 2024 Chengdu Xingrong Environment had debt of CN¥18.9b, up from CN¥11.9b in one year. However, it does have CN¥4.50b in cash offsetting this, leading to net debt of about CN¥14.5b.

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¥8.74b due within 12 months and liabilities of CN¥19.2b due beyond that. Offsetting this, it had CN¥4.50b in cash and CN¥3.84b in receivables that were due within 12 months. So it has liabilities totalling CN¥19.6b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥20.6b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt to EBITDA of 3.6 Chengdu Xingrong Environment has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.1 times its interest expense, and its net debt to EBITDA, was quite high, at 3.6. If Chengdu Xingrong Environment can keep growing EBIT at last year's rate of 12% 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 ultimately the future profitability of the business will decide if Chengdu Xingrong Environment 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Chengdu Xingrong Environment burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Chengdu Xingrong Environment's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We should also note that Water Utilities industry companies like Chengdu Xingrong Environment commonly do use debt without problems. 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. 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. We've identified 2 warning signs with Chengdu Xingrong Environment (at least 1 which is significant) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.