These 4 Measures Indicate That China Water Industry Group (HKG:1129) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that China Water Industry Group Limited (HKG:1129) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for China Water Industry Group

What Is China Water Industry Group's Debt?

As you can see below, China Water Industry Group had HK$658.1m of debt at June 2021, down from HK$901.5m a year prior. However, because it has a cash reserve of HK$411.0m, its net debt is less, at about HK$247.1m.

How Healthy Is China Water Industry Group's Balance Sheet?

According to the last reported balance sheet, China Water Industry Group had liabilities of HK$1.51b due within 12 months, and liabilities of HK$364.6m due beyond 12 months. Offsetting this, it had HK$411.0m in cash and HK$921.0m in receivables that were due within 12 months. So its liabilities total HK$547.6m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's HK$431.1m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

While China Water Industry Group's low debt to EBITDA ratio of 0.57 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.4 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. One way China Water Industry Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Water Industry Group 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, 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. Looking at the most recent three years, China Water Industry Group recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

China Water Industry Group's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its net debt to EBITDA was re-invigorating. It's also worth noting that China Water Industry Group is in the Water Utilities industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that China Water Industry Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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, we've discovered 1 warning sign for China Water Industry Group that you should be aware of before investing here.

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.

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.

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