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

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Taizhou Water Group Co., Ltd. (HKG:1542) does use debt in its business. But is this debt a concern to shareholders?

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What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Taizhou Water Group Carry?

The chart below, which you can click on for greater detail, shows that Taizhou Water Group had CN¥3.67b in debt in December 2024; about the same as the year before. However, it also had CN¥323.5m in cash, and so its net debt is CN¥3.35b.

How Healthy Is Taizhou Water Group's Balance Sheet?

We can see from the most recent balance sheet that Taizhou Water Group had liabilities of CN¥1.10b falling due within a year, and liabilities of CN¥3.62b due beyond that. On the other hand, it had cash of CN¥323.5m and CN¥158.2m worth of receivables due within a year. So it has liabilities totalling CN¥4.24b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥311.6m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. 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.

Check out our latest analysis for Taizhou Water Group

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).

Taizhou Water Group shareholders face the double whammy of a high net debt to EBITDA ratio (14.2), and fairly weak interest coverage, since EBIT is just 0.31 times the interest expense. The debt burden here is substantial. Worse, Taizhou Water Group's EBIT was down 29% over the last year. 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 you can't view debt in total isolation; since Taizhou Water Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Taizhou Water Group 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 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. We should also note that Water Utilities industry companies like Taizhou Water Group commonly do use debt without problems. It looks to us like Taizhou Water Group carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. We've identified 3 warning signs with Taizhou Water Group (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.

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.