Kangda International Environmental (HKG:6136) Seems To Be Using A Lot Of Debt

Warren Buffett famously said, '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 Kangda International Environmental Company Limited (HKG:6136) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Kangda International Environmental

How Much Debt Does Kangda International Environmental Carry?

The chart below, which you can click on for greater detail, shows that Kangda International Environmental had CN¥9.27b in debt in December 2020; about the same as the year before. However, it does have CN¥430.3m in cash offsetting this, leading to net debt of about CN¥8.84b.

How Healthy Is Kangda International Environmental's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kangda International Environmental had liabilities of CN¥4.58b due within 12 months and liabilities of CN¥7.95b due beyond that. On the other hand, it had cash of CN¥430.3m and CN¥3.44b worth of receivables due within a year. So it has liabilities totalling CN¥8.66b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥1.24b 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. At the end of the day, Kangda International Environmental would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 2.1 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Kangda International Environmental like a one-two punch to the gut. The debt burden here is substantial. On a lighter note, we note that Kangda International Environmental grew its EBIT by 21% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 Kangda International Environmental 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Kangda International Environmental recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both Kangda International Environmental's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Kangda International Environmental is in the Water Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that Kangda International Environmental's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example Kangda International Environmental has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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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