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.' 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 China Suntien Green Energy Corporation Limited (HKG:956) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for China Suntien Green Energy
What Is China Suntien Green Energy's Debt?
As you can see below, at the end of September 2022, China Suntien Green Energy had CN¥38.9b of debt, up from CN¥35.3b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥6.12b, its net debt is less, at about CN¥32.8b.
A Look At China Suntien Green Energy's Liabilities
The latest balance sheet data shows that China Suntien Green Energy had liabilities of CN¥17.9b due within a year, and liabilities of CN¥31.8b falling due after that. Offsetting these obligations, it had cash of CN¥6.12b as well as receivables valued at CN¥8.43b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥35.1b.
Given this deficit is actually higher than the company's market capitalization of CN¥29.5b, 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. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
China Suntien Green Energy has a rather high debt to EBITDA ratio of 5.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.3 times, suggesting it can responsibly service its obligations. The good news is that China Suntien Green Energy improved its EBIT by 2.9% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. 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're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, China Suntien Green Energy 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
To be frank both China Suntien Green Energy's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. We're quite clear that we consider China Suntien Green Energy to be really rather risky, as a result of its balance sheet health. 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 instance, we've identified 3 warning signs for China Suntien Green Energy (1 is potentially serious) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
About SEHK:956
China Suntien Green Energy
Develops and utilizes clean energy in Mainland China.
Undervalued with moderate growth potential.