Here's Why Capital Environment Holdings (HKG:3989) Is Weighed Down By Its Debt Load

Warren Buffett famously said, '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. We note that Capital Environment Holdings Limited (HKG:3989) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Capital Environment Holdings

How Much Debt Does Capital Environment Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Capital Environment Holdings had CN¥11.7b of debt, an increase on CN¥9.42b, over one year. However, it does have CN¥2.77b in cash offsetting this, leading to net debt of about CN¥8.90b.

How Strong Is Capital Environment Holdings' Balance Sheet?

The latest balance sheet data shows that Capital Environment Holdings had liabilities of CN¥8.52b due within a year, and liabilities of CN¥8.35b falling due after that. On the other hand, it had cash of CN¥2.77b and CN¥2.11b worth of receivables due within a year. So its liabilities total CN¥12.0b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥1.66b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Capital Environment Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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

Capital Environment Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (5.7), and fairly weak interest coverage, since EBIT is just 2.5 times the interest expense. The debt burden here is substantial. The good news is that Capital Environment Holdings grew its EBIT a smooth 35% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing 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 Capital Environment Holdings 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Capital Environment Holdings 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

On the face of it, Capital Environment Holdings'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 at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Capital Environment Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Capital Environment Holdings that you should be aware of before investing here.

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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