Canvest Environmental Protection Group (HKG:1381) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Canvest Environmental Protection Group Company Limited (HKG:1381) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Canvest Environmental Protection Group

How Much Debt Does Canvest Environmental Protection Group Carry?

The image below, which you can click on for greater detail, shows that at June 2020 Canvest Environmental Protection Group had debt of HK$6.65b, up from HK$4.58b in one year. However, it also had HK$1.30b in cash, and so its net debt is HK$5.35b.

How Strong Is Canvest Environmental Protection Group's Balance Sheet?

According to the last reported balance sheet, Canvest Environmental Protection Group had liabilities of HK$2.36b due within 12 months, and liabilities of HK$6.32b due beyond 12 months. Offsetting these obligations, it had cash of HK$1.30b as well as receivables valued at HK$1.10b due within 12 months. So it has liabilities totalling HK$6.28b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$8.15b, so it does suggest shareholders should keep an eye on Canvest Environmental Protection Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Canvest Environmental Protection Group has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 5.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Canvest Environmental Protection Group grew its EBIT by 9.9% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Canvest Environmental Protection Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Canvest Environmental Protection Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We'd go so far as to say Canvest Environmental Protection Group's conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Canvest Environmental Protection Group has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Canvest Environmental Protection Group has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. 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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