Does Zhongshan Public Utilities GroupLtd (SZSE:000685) 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Zhongshan Public Utilities Group Co.,Ltd (SZSE:000685) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Zhongshan Public Utilities GroupLtd

How Much Debt Does Zhongshan Public Utilities GroupLtd Carry?

As you can see below, at the end of June 2024, Zhongshan Public Utilities GroupLtd had CN¥8.09b of debt, up from CN¥7.12b a year ago. Click the image for more detail. On the flip side, it has CN¥1.78b in cash leading to net debt of about CN¥6.31b.

How Strong Is Zhongshan Public Utilities GroupLtd's Balance Sheet?

We can see from the most recent balance sheet that Zhongshan Public Utilities GroupLtd had liabilities of CN¥5.78b falling due within a year, and liabilities of CN¥7.50b due beyond that. Offsetting this, it had CN¥1.78b in cash and CN¥3.07b in receivables that were due within 12 months. So it has liabilities totalling CN¥8.43b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥12.7b, so it does suggest shareholders should keep an eye on Zhongshan Public Utilities GroupLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

As it happens Zhongshan Public Utilities GroupLtd has a fairly concerning net debt to EBITDA ratio of 6.2 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. It is well worth noting that Zhongshan Public Utilities GroupLtd's EBIT shot up like bamboo after rain, gaining 31% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Zhongshan Public Utilities GroupLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Zhongshan Public Utilities GroupLtd 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 feel some trepidation about Zhongshan Public Utilities GroupLtd's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We should also note that Water Utilities industry companies like Zhongshan Public Utilities GroupLtd commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Zhongshan Public Utilities GroupLtd is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zhongshan Public Utilities GroupLtd is showing 3 warning signs in our investment analysis , and 1 of those is concerning...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.