Here's Why China Energy Engineering (HKG:3996) Is Weighed Down By Its Debt Load

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 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 China Energy Engineering Corporation Limited (HKG:3996) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for China Energy Engineering

What Is China Energy Engineering's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2021 China Energy Engineering had debt of CN¥127.9b, up from CN¥114.1b in one year. On the flip side, it has CN¥61.5b in cash leading to net debt of about CN¥66.4b.

How Strong Is China Energy Engineering's Balance Sheet?

The latest balance sheet data shows that China Energy Engineering had liabilities of CN¥270.5b due within a year, and liabilities of CN¥108.6b falling due after that. Offsetting these obligations, it had cash of CN¥61.5b as well as receivables valued at CN¥152.1b due within 12 months. So its liabilities total CN¥165.5b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥37.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, China Energy Engineering would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

China Energy Engineering has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 6.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way China Energy Engineering could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, 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 China Energy Engineering's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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, China Energy Engineering 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

On the face of it, China Energy Engineering's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider China Energy Engineering to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Be aware that China Energy Engineering is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

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.