Taizhou Water Group (HKG:1542) Use Of Debt Could Be Considered Risky

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Taizhou Water Group Co., Ltd. (HKG:1542) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Taizhou Water Group

How Much Debt Does Taizhou Water Group Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Taizhou Water Group had debt of CN¥3.32b, up from CN¥3.10b in one year. However, because it has a cash reserve of CN¥260.0m, its net debt is less, at about CN¥3.06b.

How Strong Is Taizhou Water Group's Balance Sheet?

According to the last reported balance sheet, Taizhou Water Group had liabilities of CN¥1.23b due within 12 months, and liabilities of CN¥3.38b due beyond 12 months. Offsetting this, it had CN¥260.0m in cash and CN¥157.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥4.19b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥381.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Taizhou Water Group would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Taizhou Water Group shareholders face the double whammy of a high net debt to EBITDA ratio (12.4), and fairly weak interest coverage, since EBIT is just 0.99 times the interest expense. The debt burden here is substantial. Even worse, Taizhou Water Group saw its EBIT tank 35% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Taizhou Water Group will need earnings to service that debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Taizhou Water Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Taizhou Water Group's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It's also worth noting that Taizhou Water Group is in the Water Utilities industry, which is often considered to be quite defensive. Considering everything we've mentioned above, it's fair to say that Taizhou Water Group is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Taizhou Water Group (of which 2 are significant!) 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.