Is ELL Environmental Holdings (HKG:1395) A Risky Investment?

Warren Buffett famously said, '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 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 Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for ELL Environmental Holdings

How Much Debt Does ELL Environmental Holdings Carry?

As you can see below, ELL Environmental Holdings had HK$22.5m of debt at June 2020, down from HK$39.4m a year prior. However, its balance sheet shows it holds HK$51.2m in cash, so it actually has HK$28.7m net cash.

A Look At ELL Environmental Holdings's Liabilities

The latest balance sheet data shows that ELL Environmental Holdings had liabilities of HK$42.3m due within a year, and liabilities of HK$51.4m falling due after that. Offsetting these obligations, it had cash of HK$51.2m as well as receivables valued at HK$31.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$10.8m.

Given ELL Environmental Holdings has a market capitalization of HK$103.0m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, ELL Environmental Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

Although ELL Environmental Holdings made a loss at the EBIT level, last year, it was also good to see that it generated HK$18m in EBIT over the last twelve months. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. Over the most recent year, ELL Environmental Holdings recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

Although ELL Environmental Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$28.7m. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in HK$14m. So is ELL Environmental Holdings's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for ELL Environmental Holdings that you should be aware of.

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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