Does Dongjiang Environmental (HKG:895) Have A Healthy Balance Sheet?

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 Dongjiang Environmental Company Limited (HKG:895) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that 895 is potentially overvalued!

How Much Debt Does Dongjiang Environmental Carry?

As you can see below, at the end of June 2022, Dongjiang Environmental had CN¥5.18b of debt, up from CN¥4.17b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥670.5m, its net debt is less, at about CN¥4.51b.

How Strong Is Dongjiang Environmental's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Dongjiang Environmental had liabilities of CN¥3.62b due within 12 months and liabilities of CN¥3.04b due beyond that. On the other hand, it had cash of CN¥670.5m and CN¥1.61b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.38b.

Given this deficit is actually higher than the company's market capitalization of CN¥4.11b, we think shareholders really should watch Dongjiang Environmental's debt levels, like a parent watching their child ride a bike for the first time. 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 5.7 hit our confidence in Dongjiang Environmental like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Dongjiang Environmental's EBIT was down 52% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Dongjiang Environmental's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Dongjiang Environmental burned a lot of cash. 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, Dongjiang Environmental'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 furthermore, its interest cover also fails to instill confidence. We think the chances that Dongjiang Environmental 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Dongjiang Environmental has 2 warning signs (and 1 which is potentially serious) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.