Here's Why China Water Affairs Group (HKG:855) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies China Water Affairs Group Limited (HKG:855) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 China Water Affairs Group

What Is China Water Affairs Group's Debt?

The image below, which you can click on for greater detail, shows that at September 2021 China Water Affairs Group had debt of HK$20.9b, up from HK$19.5b in one year. However, it does have HK$5.71b in cash offsetting this, leading to net debt of about HK$15.2b.

How Strong Is China Water Affairs Group's Balance Sheet?

According to the last reported balance sheet, China Water Affairs Group had liabilities of HK$15.8b due within 12 months, and liabilities of HK$17.8b due beyond 12 months. Offsetting these obligations, it had cash of HK$5.71b as well as receivables valued at HK$4.73b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$23.1b.

Given this deficit is actually higher than the company's market capitalization of HK$16.9b, we think shareholders really should watch China Water Affairs Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

China Water Affairs Group's net debt is 3.3 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 15.5 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We note that China Water Affairs Group grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Water Affairs Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, China Water Affairs Group recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, China Water Affairs Group's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like China Water Affairs Group commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making China Water Affairs Group stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that China Water Affairs Group is showing 4 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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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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.