Canvest Environmental Protection Group (HKG:1381) Use Of Debt Could Be Considered Risky

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Canvest Environmental Protection Group Company Limited (HKG:1381) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Canvest Environmental Protection Group

What Is Canvest Environmental Protection Group's Debt?

As you can see below, Canvest Environmental Protection Group had HK$13.7b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had HK$1.86b in cash, and so its net debt is HK$11.9b.

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

The latest balance sheet data shows that Canvest Environmental Protection Group had liabilities of HK$4.00b due within a year, and liabilities of HK$13.2b falling due after that. On the other hand, it had cash of HK$1.86b and HK$2.73b worth of receivables due within a year. So it has liabilities totalling HK$12.7b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's HK$8.81b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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 4.2 and its EBIT covered its interest expense 3.2 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Given the debt load, it's hardly ideal that Canvest Environmental Protection Group's EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Canvest Environmental Protection Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by 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

On the face of it, Canvest Environmental Protection Group's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think Canvest Environmental Protection Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 - Canvest Environmental Protection Group has 1 warning sign 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.