Here's Why Luzhou Xinglu Water (Group) (HKG:2281) Has A Meaningful Debt Burden

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.' 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 Luzhou Xinglu Water (Group) Co., Ltd. (HKG:2281) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. 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.

View our latest analysis for Luzhou Xinglu Water (Group)

What Is Luzhou Xinglu Water (Group)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Luzhou Xinglu Water (Group) had CN¥2.33b of debt, an increase on CN¥2.13b, over one year. However, because it has a cash reserve of CN¥1.02b, its net debt is less, at about CN¥1.31b.

A Look At Luzhou Xinglu Water (Group)'s Liabilities

According to the last reported balance sheet, Luzhou Xinglu Water (Group) had liabilities of CN¥1.29b due within 12 months, and liabilities of CN¥2.92b due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.02b as well as receivables valued at CN¥509.7m due within 12 months. So it has liabilities totalling CN¥2.68b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥771.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Luzhou Xinglu 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Luzhou Xinglu Water (Group) has a debt to EBITDA ratio of 2.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 22.5 is very high, suggesting that the interest expense on the debt is currently quite low. If Luzhou Xinglu Water (Group) can keep growing EBIT at last year's rate of 18% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Luzhou Xinglu Water (Group)'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Luzhou Xinglu 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

On the face of it, Luzhou Xinglu Water (Group)'s conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We should also note that Water Utilities industry companies like Luzhou Xinglu Water (Group) commonly do use debt without problems. Overall, we think it's fair to say that Luzhou Xinglu Water (Group) has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example Luzhou Xinglu Water (Group) has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.
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