Does ELL Environmental Holdings (HKG:1395) Have A Healthy Balance Sheet?

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.' 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 ELL Environmental Holdings Limited (HKG:1395) does have debt on its balance sheet. But is this debt a concern to shareholders?

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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. 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, 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.

What Is ELL Environmental Holdings's Debt?

As you can see below, at the end of December 2024, ELL Environmental Holdings had HK$202.1m of debt, up from HK$184.1m a year ago. Click the image for more detail. On the flip side, it has HK$35.2m in cash leading to net debt of about HK$166.9m.

A Look At ELL Environmental Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that ELL Environmental Holdings had liabilities of HK$110.9m due within 12 months and liabilities of HK$153.0m due beyond that. Offsetting this, it had HK$35.2m in cash and HK$39.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$189.7m.

When you consider that this deficiency exceeds the company's HK$160.6m 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.

View our latest analysis for ELL Environmental Holdings

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.6 times and a disturbingly high net debt to EBITDA ratio of 7.1 hit our confidence in ELL Environmental Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. On a lighter note, we note that ELL Environmental Holdings grew its EBIT by 28% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since ELL Environmental Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, ELL Environmental Holdings burned a lot of cash. 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

To be frank both ELL Environmental Holdings's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that ELL Environmental Holdings is in the Water Utilities industry, which is often considered to be quite defensive. We're quite clear that we consider ELL Environmental Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that ELL Environmental Holdings is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.