Is Zhejiang Tengy Environmental Technology (HKG:1527) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Zhejiang Tengy Environmental Technology Co., Ltd (HKG:1527) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Zhejiang Tengy Environmental Technology

What Is Zhejiang Tengy Environmental Technology's Net Debt?

As you can see below, Zhejiang Tengy Environmental Technology had CN¥106.8m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥6.40m in cash leading to net debt of about CN¥100.4m.

A Look At Zhejiang Tengy Environmental Technology's Liabilities

Zooming in on the latest balance sheet data, we can see that Zhejiang Tengy Environmental Technology had liabilities of CN¥773.2m due within 12 months and no liabilities due beyond that. Offsetting these obligations, it had cash of CN¥6.40m as well as receivables valued at CN¥954.2m due within 12 months. So it actually has CN¥187.4m more liquid assets than total liabilities.

This surplus liquidity suggests that Zhejiang Tengy Environmental Technology's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.71 times and a disturbingly high net debt to EBITDA ratio of 10.1 hit our confidence in Zhejiang Tengy Environmental Technology like a one-two punch to the gut. The debt burden here is substantial. Worse, Zhejiang Tengy Environmental Technology's EBIT was down 89% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Zhejiang Tengy Environmental Technology 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Zhejiang Tengy Environmental Technology saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Zhejiang Tengy Environmental Technology's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Once we consider all the factors above, together, it seems to us that Zhejiang Tengy Environmental Technology's debt is making it 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. Case in point: We've spotted 3 warning signs for Zhejiang Tengy Environmental Technology you should be aware of, and 1 of them is potentially serious.

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. 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.
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