These 4 Measures Indicate That China Everbright Water (SGX:U9E) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that China Everbright Water Limited (SGX:U9E) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for China Everbright Water

How Much Debt Does China Everbright Water Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 China Everbright Water had HK$11.1b of debt, an increase on HK$9.08b, over one year. However, it does have HK$1.72b in cash offsetting this, leading to net debt of about HK$9.36b.

How Strong Is China Everbright Water's Balance Sheet?

According to the last reported balance sheet, China Everbright Water had liabilities of HK$4.87b due within 12 months, and liabilities of HK$10.6b due beyond 12 months. On the other hand, it had cash of HK$1.72b and HK$3.46b worth of receivables due within a year. So its liabilities total HK$10.3b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$4.04b 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 definitely think shareholders need to watch this one closely. At the end of the day, China Everbright Water would probably need a major re-capitalization if its creditors were to demand repayment.

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 5.1, it's fair to say China Everbright Water does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 5.3 times, suggesting it can responsibly service its obligations. Also relevant is that China Everbright Water has grown its EBIT by a very respectable 24% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Everbright Water can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Everbright Water 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 China Everbright Water'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. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Water Utilities industry companies like China Everbright Water commonly do use debt without problems. We're quite clear that we consider China Everbright Water to be really rather risky, as a result of its balance sheet health. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for China Everbright Water (1 is potentially serious!) that you should be aware of before investing here.

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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