We Think China Environmental Energy Investment (HKG:986) Can Stay On Top Of Its Debt

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.' 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 is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for China Environmental Energy Investment

How Much Debt Does China Environmental Energy Investment Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2021 China Environmental Energy Investment had HK$22.5m of debt, an increase on HK$16.1m, over one year. However, it also had HK$1.54m in cash, and so its net debt is HK$21.0m.

How Healthy Is China Environmental Energy Investment's Balance Sheet?

According to the last reported balance sheet, China Environmental Energy Investment had liabilities of HK$34.5m due within 12 months, and liabilities of HK$16.1m due beyond 12 months. Offsetting these obligations, it had cash of HK$1.54m as well as receivables valued at HK$74.0m due within 12 months. So it can boast HK$25.0m more liquid assets than total liabilities.

This surplus strongly suggests that China Environmental Energy Investment has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is as strong as an ox.

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). 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).

China Environmental Energy Investment's net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. We also note that China Environmental Energy Investment improved its EBIT from a last year's loss to a positive HK$8.9m. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, China Environmental Energy Investment actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Happily, China Environmental Energy Investment's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that China Environmental Energy Investment can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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 4 warning signs we've spotted with China Environmental Energy Investment (including 1 which is a bit 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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