Kunming Dianchi Water Treatment (HKG:3768) Has No Shortage Of Debt

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 Kunming Dianchi Water Treatment Co., Ltd. (HKG:3768) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Kunming Dianchi Water Treatment

What Is Kunming Dianchi Water Treatment's Net Debt?

As you can see below, Kunming Dianchi Water Treatment had CN¥5.02b of debt at June 2024, down from CN¥5.80b a year prior. And it doesn't have much cash, so its net debt is about the same.

How Healthy 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¥4.73b falling due within a year, and liabilities of CN¥2.10b due beyond that. On the other hand, it had cash of CN¥76.9m and CN¥5.28b worth of receivables due within a year. So it has liabilities totalling CN¥1.48b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥557.5m 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 6.0, it's fair to say Kunming Dianchi Water Treatment does have a significant amount of debt. However, its interest coverage of 2.7 is reasonably strong, which is a good sign. Another concern for investors might be that Kunming Dianchi Water Treatment's EBIT fell 15% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. 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.

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. 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

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 EBIT growth rate also fails to instill confidence. We should also note that Water Utilities industry companies like Kunming Dianchi Water Treatment commonly do use debt without problems. Considering all the factors previously mentioned, we think that Kunming Dianchi Water Treatment really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. 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. To that end, you should learn about the 3 warning signs we've spotted with Kunming Dianchi Water Treatment (including 2 which are a bit unpleasant) .

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.