We Think Chengdu Xingrong Environment (SZSE:000598) 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.' 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 should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

View our latest analysis for Chengdu Xingrong Environment

What Is Chengdu Xingrong Environment's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Chengdu Xingrong Environment had debt of CN¥19.1b, up from CN¥10.7b in one year. However, because it has a cash reserve of CN¥5.42b, its net debt is less, at about CN¥13.7b.

How Strong Is Chengdu Xingrong Environment's Balance Sheet?

According to the last reported balance sheet, Chengdu Xingrong Environment had liabilities of CN¥8.90b due within 12 months, and liabilities of CN¥18.8b due beyond 12 months. Offsetting this, it had CN¥5.42b in cash and CN¥3.63b in receivables that were due within 12 months. So its liabilities total CN¥18.6b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥21.8b. 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).

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 8.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.6. One way Chengdu Xingrong Environment could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by 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

We'd go so far as to say Chengdu Xingrong Environment's conversion of EBIT to free cash flow was disappointing. But on the bright side, its interest cover 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. Once we consider all the factors above, together, it seems to us that Chengdu Xingrong Environment's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 example, we've discovered 2 warning signs for Chengdu Xingrong Environment (1 doesn't sit too well with us!) that you should be aware of before investing here.

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.