ELL Environmental Holdings (HKG:1395) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that ELL Environmental Holdings Limited (HKG:1395) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 ELL Environmental Holdings

What Is ELL Environmental Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 ELL Environmental Holdings had HK$74.3m of debt, an increase on HK$35.9m, over one year. However, its balance sheet shows it holds HK$77.3m in cash, so it actually has HK$3.01m net cash.

How Healthy Is ELL Environmental Holdings' Balance Sheet?

We can see from the most recent balance sheet that ELL Environmental Holdings had liabilities of HK$85.0m falling due within a year, and liabilities of HK$60.7m due beyond that. Offsetting this, it had HK$77.3m in cash and HK$25.6m in receivables that were due within 12 months. So it has liabilities totalling HK$42.7m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since ELL Environmental Holdings has a market capitalization of HK$199.3m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, ELL Environmental Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, ELL Environmental Holdings grew its EBIT by 1,205% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While ELL Environmental Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, ELL Environmental Holdings produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While ELL Environmental Holdings does have more liabilities than liquid assets, it also has net cash of HK$3.01m. And we liked the look of last year's 1,205% year-on-year EBIT growth. So is ELL Environmental Holdings's debt a risk? It doesn't seem so to us. 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. Be aware that ELL Environmental Holdings is showing 2 warning signs in our investment analysis , 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.