Is Zhongshan Public Utilities GroupLtd (SZSE:000685) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Zhongshan Public Utilities Group Co.,Ltd (SZSE:000685) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Zhongshan Public Utilities GroupLtd

What Is Zhongshan Public Utilities GroupLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Zhongshan Public Utilities GroupLtd had CN¥8.06b of debt, an increase on CN¥3.78b, over one year. However, because it has a cash reserve of CN¥1.59b, its net debt is less, at about CN¥6.47b.

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

The latest balance sheet data shows that Zhongshan Public Utilities GroupLtd had liabilities of CN¥6.80b due within a year, and liabilities of CN¥5.56b falling due after that. On the other hand, it had cash of CN¥1.59b and CN¥2.20b worth of receivables due within a year. So its liabilities total CN¥8.57b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CN¥10.7b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Zhongshan Public Utilities GroupLtd has a fairly concerning net debt to EBITDA ratio of 6.4 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 62% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Zhongshan Public Utilities GroupLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. 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

While Zhongshan Public Utilities GroupLtd's conversion of EBIT to free cash flow has us nervous. 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. Taking the abovementioned factors together we do think Zhongshan Public Utilities GroupLtd'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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Zhongshan Public Utilities GroupLtd that you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com