Is China Water Affairs Group (HKG:855) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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, China Water Affairs Group Limited (HKG:855) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for China Water Affairs Group

How Much Debt Does China Water Affairs Group Carry?

The image below, which you can click on for greater detail, shows that at September 2020 China Water Affairs Group had debt of HK$19.5b, up from HK$16.2b in one year. On the flip side, it has HK$5.59b in cash leading to net debt of about HK$13.9b.

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

The latest balance sheet data shows that China Water Affairs Group had liabilities of HK$12.7b due within a year, and liabilities of HK$17.1b falling due after that. Offsetting this, it had HK$5.59b in cash and HK$3.51b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$20.6b.

This deficit casts a shadow over the HK$9.64b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Water Affairs Group 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Water Affairs Group has a debt to EBITDA ratio of 3.6, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 15.5 is very high, suggesting that the interest expense on the debt is currently quite low. If China Water Affairs Group can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, China Water Affairs Group saw substantial negative free cash flow, in total. 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, China Water Affairs Group'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. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that China Water Affairs Group is in the Water Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that China Water Affairs Group's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. To that end, you should learn about the 2 warning signs we've spotted with China Water Affairs Group (including 1 which doesn't sit too well with us) .

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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This article by Simply Wall St is general in nature. 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.
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