These 4 Measures Indicate That Datang Environment Industry Group (HKG:1272) Is Using Debt In A Risky Way

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Datang Environment Industry Group Co., Ltd. (HKG:1272) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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, 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.

Check out our latest analysis for Datang Environment Industry Group

What Is Datang Environment Industry Group's Net Debt?

As you can see below, Datang Environment Industry Group had CN¥5.42b of debt at September 2020, down from CN¥6.01b a year prior. However, because it has a cash reserve of CN¥1.11b, its net debt is less, at about CN¥4.31b.

How Strong Is Datang Environment Industry Group's Balance Sheet?

According to the last reported balance sheet, Datang Environment Industry Group had liabilities of CN¥10.6b due within 12 months, and liabilities of CN¥3.13b due beyond 12 months. Offsetting this, it had CN¥1.11b in cash and CN¥10.3b in receivables that were due within 12 months. So it has liabilities totalling CN¥2.40b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥1.93b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

While Datang Environment Industry Group's debt to EBITDA ratio (3.4) suggests that it uses some debt, its interest cover is very weak, at 1.5, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Datang Environment Industry Group's EBIT was down 49% 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 it is Datang Environment Industry Group's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Datang Environment Industry Group 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, Datang Environment Industry Group's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its level of total liabilities fails to inspire much confidence. We think the chances that Datang Environment Industry Group has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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 example Datang Environment Industry Group has 4 warning signs (and 2 which are potentially serious) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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