China Water Industry Group (HKG:1129) Has A Somewhat Strained Balance Sheet

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.' 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 note that China Water Industry Group Limited (HKG:1129) 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

View our latest analysis for China Water Industry Group

How Much Debt Does China Water Industry Group Carry?

The chart below, which you can click on for greater detail, shows that China Water Industry Group had HK$901.5m in debt in June 2020; about the same as the year before. But it also has HK$928.0m in cash to offset that, meaning it has HK$26.5m net cash.

A Look At China Water Industry Group's Liabilities

According to the last reported balance sheet, China Water Industry Group had liabilities of HK$2.35b due within 12 months, and liabilities of HK$807.2m due beyond 12 months. Offsetting these obligations, it had cash of HK$928.0m as well as receivables valued at HK$1.01b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.22b.

The deficiency here weighs heavily on the HK$391.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, China Water Industry Group would likely require a major re-capitalisation if it had to pay its creditors today. Given that China Water Industry Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

Importantly, China Water Industry Group grew its EBIT by 46% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is China Water Industry Group'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. China Water Industry Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, China Water Industry Group's free cash flow amounted to 34% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

Although China Water Industry Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$26.5m. And we liked the look of last year's 46% year-on-year EBIT growth. So although we see some areas for improvement, we're not too worried about China Water Industry Group's balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with China Water Industry Group .

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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