These 4 Measures Indicate That China Environmental Energy Investment (HKG:986) Is Using Debt Reasonably Well

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that China Environmental Energy Investment Limited (HKG:986) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for China Environmental Energy Investment

What Is China Environmental Energy Investment's Net Debt?

You can click the graphic below for the historical numbers, but it shows that China Environmental Energy Investment had HK$20.1m of debt in March 2023, down from HK$25.7m, one year before. However, because it has a cash reserve of HK$1.35m, its net debt is less, at about HK$18.8m.

A Look At China Environmental Energy Investment's Liabilities

The latest balance sheet data shows that China Environmental Energy Investment had liabilities of HK$38.4m due within a year, and liabilities of HK$9.03m falling due after that. On the other hand, it had cash of HK$1.35m and HK$213.5m worth of receivables due within a year. So it actually has HK$167.4m more liquid assets than total liabilities.

This excess liquidity is a great indication that China Environmental Energy Investment's balance sheet is almost as strong as Fort Knox. On this view, lenders should feel as safe as the beloved of a black-belt karate master.

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.

We'd say that China Environmental Energy Investment's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 10.1 times, makes us even more comfortable. Pleasingly, China Environmental Energy Investment is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 308% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is China Environmental Energy Investment's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, China Environmental Energy Investment saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, China Environmental Energy Investment's impressive EBIT growth rate implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at the bigger picture, we think China Environmental Energy Investment's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - China Environmental Energy Investment has 2 warning signs we think you should be aware of.

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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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.