Does Kunming Dianchi Water Treatment (HKG:3768) Have A Healthy Balance Sheet?

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.' 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. We note that Kunming Dianchi Water Treatment Co., Ltd. (HKG:3768) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Kunming Dianchi Water Treatment

How Much Debt Does Kunming Dianchi Water Treatment Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Kunming Dianchi Water Treatment had debt of CN¥4.96b, up from CN¥4.57b in one year. However, it does have CN¥749.9m in cash offsetting this, leading to net debt of about CN¥4.21b.

How Strong Is Kunming Dianchi Water Treatment's Balance Sheet?

We can see from the most recent balance sheet that Kunming Dianchi Water Treatment had liabilities of CN¥2.81b falling due within a year, and liabilities of CN¥3.41b due beyond that. Offsetting these obligations, it had cash of CN¥749.9m as well as receivables valued at CN¥2.36b due within 12 months. So its liabilities total CN¥3.11b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥1.77b 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'd watch its balance sheet closely, without a doubt. After all, Kunming Dianchi Water Treatment would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 5.8, it's fair to say Kunming Dianchi Water Treatment does have a significant amount of debt. However, its interest coverage of 3.5 is reasonably strong, which is a good sign. Even more troubling is the fact that Kunming Dianchi Water Treatment actually let its EBIT decrease by 7.0% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its 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 Kunming Dianchi Water Treatment 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Kunming Dianchi Water Treatment 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, Kunming Dianchi Water Treatment'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. And furthermore, its interest cover also fails to instill confidence. It's also worth noting that Kunming Dianchi Water Treatment is in the Water Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think Kunming Dianchi Water Treatment has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Kunming Dianchi Water Treatment (of which 1 makes us a bit uncomfortable!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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