ELL Environmental Holdings (HKG:1395) Has No Shortage Of Debt

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. As with many other companies ELL Environmental Holdings Limited (HKG:1395) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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, 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.

Check out our latest analysis for ELL Environmental Holdings

How Much Debt Does ELL Environmental Holdings Carry?

The image below, which you can click on for greater detail, shows that ELL Environmental Holdings had debt of HK$179.0m at the end of June 2024, a reduction from HK$188.5m over a year. However, because it has a cash reserve of HK$15.3m, its net debt is less, at about HK$163.7m.

How Healthy Is ELL Environmental Holdings' Balance Sheet?

According to the last reported balance sheet, ELL Environmental Holdings had liabilities of HK$48.9m due within 12 months, and liabilities of HK$196.6m due beyond 12 months. Offsetting this, it had HK$15.3m in cash and HK$31.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$198.3m.

Given this deficit is actually higher than the company's market capitalization of HK$138.4m, we think shareholders really should watch ELL Environmental Holdings'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 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). 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).

ELL Environmental Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (10.3), and fairly weak interest coverage, since EBIT is just 0.92 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, ELL Environmental Holdings saw its EBIT tank 45% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is ELL Environmental Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Over the last three years, ELL Environmental Holdings 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, ELL Environmental Holdings's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its net debt to EBITDA also fails to instill confidence. It's also worth noting that ELL Environmental Holdings is in the Water Utilities industry, which is often considered to be quite defensive. We think the chances that ELL Environmental Holdings has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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 ELL Environmental Holdings has 3 warning signs (and 2 which are a bit concerning) we think 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.