Is Datang Environment Industry Group (HKG:1272) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Datang Environment Industry Group Co., Ltd. (HKG:1272) makes use of debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 Datang Environment Industry Group

What Is Datang Environment Industry Group's Debt?

The image below, which you can click on for greater detail, shows that Datang Environment Industry Group had debt of CN¥3.73b at the end of March 2021, a reduction from CN¥5.71b over a year. However, it does have CN¥705.9m in cash offsetting this, leading to net debt of about CN¥3.02b.

A Look At Datang Environment Industry Group's Liabilities

We can see from the most recent balance sheet that Datang Environment Industry Group had liabilities of CN¥9.82b falling due within a year, and liabilities of CN¥2.66b due beyond that. Offsetting this, it had CN¥705.9m in cash and CN¥9.80b in receivables that were due within 12 months. So its liabilities total CN¥1.98b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥2.95b, so it does suggest shareholders should keep an eye on Datang Environment Industry Group's use of debt. 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). 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).

Datang Environment Industry Group has net debt worth 2.0 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.1 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Importantly, Datang Environment Industry Group grew its EBIT by 47% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Datang Environment Industry Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Datang Environment Industry Group burned a lot of cash. 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

Neither Datang Environment Industry Group's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Datang Environment Industry Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Datang Environment Industry Group is showing 5 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.

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