China Suntien Green Energy (HKG:956) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that China Suntien Green Energy Corporation Limited (HKG:956) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Suntien Green Energy

How Much Debt Does China Suntien Green Energy Carry?

The image below, which you can click on for greater detail, shows that at September 2020 China Suntien Green Energy had debt of CN¥26.2b, up from CN¥19.9b in one year. On the flip side, it has CN¥2.33b in cash leading to net debt of about CN¥23.9b.

A Look At China Suntien Green Energy's Liabilities

Zooming in on the latest balance sheet data, we can see that China Suntien Green Energy had liabilities of CN¥10.7b due within 12 months and liabilities of CN¥26.3b due beyond that. Offsetting this, it had CN¥2.33b in cash and CN¥4.99b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥29.7b.

Given this deficit is actually higher than the company's market capitalization of CN¥21.9b, we think shareholders really should watch China Suntien Green Energy's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

With a net debt to EBITDA ratio of 5.8, it's fair to say China Suntien Green Energy does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.1 times, suggesting it can responsibly service its obligations. The good news is that China Suntien Green Energy improved its EBIT by 5.6% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Suntien Green Energy can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Suntien Green Energy 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

On the face of it, China Suntien Green Energy's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think China Suntien Green Energy has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. To that end, you should learn about the 3 warning signs we've spotted with China Suntien Green Energy (including 1 which is is 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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