Is Kunming Dianchi Water Treatment (HKG:3768) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Kunming Dianchi Water Treatment Co., Ltd. (HKG:3768) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for Kunming Dianchi Water Treatment

What Is Kunming Dianchi Water Treatment's Debt?

As you can see below, Kunming Dianchi Water Treatment had CN¥5.27b of debt at December 2023, down from CN¥5.87b a year prior. On the flip side, it has CN¥174.1m in cash leading to net debt of about CN¥5.10b.

A Look At Kunming Dianchi Water Treatment's Liabilities

The latest balance sheet data shows that Kunming Dianchi Water Treatment had liabilities of CN¥4.80b due within a year, and liabilities of CN¥2.29b falling due after that. Offsetting these obligations, it had cash of CN¥174.1m as well as receivables valued at CN¥4.41b due within 12 months. So its liabilities total CN¥2.50b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥706.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Kunming Dianchi Water Treatment 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.

With a net debt to EBITDA ratio of 5.9, it's fair to say Kunming Dianchi Water Treatment does have a significant amount of debt. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. More concerning, Kunming Dianchi Water Treatment saw its EBIT drop by 7.8% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kunming Dianchi Water Treatment 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 Kunming Dianchi Water Treatment's conversion of EBIT to free cash flow 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 Kunming Dianchi Water Treatment is in the Water Utilities industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Kunming Dianchi Water Treatment has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Kunming Dianchi Water Treatment (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.