Here's Why Canvest Environmental Protection Group (HKG:1381) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Canvest Environmental Protection Group Company Limited (HKG:1381) makes use of debt. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Canvest Environmental Protection Group

What Is Canvest Environmental Protection Group's Net Debt?

As you can see below, at the end of June 2022, Canvest Environmental Protection Group had HK$14.0b of debt, up from HK$11.3b a year ago. Click the image for more detail. On the flip side, it has HK$1.85b in cash leading to net debt of about HK$12.2b.

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

According to the last reported balance sheet, Canvest Environmental Protection Group had liabilities of HK$3.85b due within 12 months, and liabilities of HK$13.3b due beyond 12 months. On the other hand, it had cash of HK$1.85b and HK$2.66b worth of receivables due within a year. So it has liabilities totalling HK$12.6b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of HK$11.4b, we think shareholders really should watch Canvest Environmental Protection Group's debt levels, like a parent watching their child ride a bike for the first time. 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). 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 4.5 and its EBIT covered its interest expense 4.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a lighter note, we note that Canvest Environmental Protection Group grew its EBIT by 23% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Canvest Environmental Protection Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Canvest Environmental Protection Group's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Canvest Environmental Protection Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Canvest Environmental Protection Group you should know about.

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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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.