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.' 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. We can see that China Environmental Energy Investment Limited (HKG:986) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is China Environmental Energy Investment's Net Debt?
As you can see below, at the end of September 2020, China Environmental Energy Investment had HK$26.1m of debt, up from HK$16.0m a year ago. Click the image for more detail. On the flip side, it has HK$16.9m in cash leading to net debt of about HK$9.16m.
How Strong Is China Environmental Energy Investment's Balance Sheet?
According to the last reported balance sheet, China Environmental Energy Investment had liabilities of HK$29.6m due within 12 months, and liabilities of HK$19.9m due beyond 12 months. Offsetting these obligations, it had cash of HK$16.9m as well as receivables valued at HK$52.2m due within 12 months. So it can boast HK$19.6m more liquid assets than total liabilities.
This short term liquidity is a sign that China Environmental Energy Investment could probably pay off its debt with ease, as its balance sheet is far from stretched. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since China Environmental Energy Investment 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.
In the last year China Environmental Energy Investment had a loss before interest and tax, and actually shrunk its revenue by 55%, to HK$64m. That makes us nervous, to say the least.
Not only did China Environmental Energy Investment's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost HK$16m at the EBIT level. Looking on the brighter side, the business has adequate liquid assets, which give it time to grow and develop before its debt becomes a near-term issue. But we'd want to see some positive free cashflow before spending much time on trying to understand the stock. This one is a bit too risky for our liking. 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 2 warning signs for China Environmental Energy Investment (1 can't be ignored) you should be aware of.
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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