Is Ever-Clear Environmental Eng (GTSM:6624) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Ever-Clear Environmental Eng. Corp. (GTSM:6624) does have debt on its balance sheet. 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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Ever-Clear Environmental Eng

What Is Ever-Clear Environmental Eng's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Ever-Clear Environmental Eng had NT$294.6m of debt, an increase on NT$248.0m, over one year. However, it also had NT$44.5m in cash, and so its net debt is NT$250.0m.

How Healthy Is Ever-Clear Environmental Eng's Balance Sheet?

We can see from the most recent balance sheet that Ever-Clear Environmental Eng had liabilities of NT$196.8m falling due within a year, and liabilities of NT$210.0m due beyond that. Offsetting these obligations, it had cash of NT$44.5m as well as receivables valued at NT$293.6m due within 12 months. So it has liabilities totalling NT$68.6m more than its cash and near-term receivables, combined.

Given Ever-Clear Environmental Eng has a market capitalization of NT$569.7m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Ever-Clear Environmental Eng shareholders face the double whammy of a high net debt to EBITDA ratio (17.4), and fairly weak interest coverage, since EBIT is just 1.9 times the interest expense. The debt burden here is substantial. Even worse, Ever-Clear Environmental Eng saw its EBIT tank 95% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is Ever-Clear Environmental Eng's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Ever-Clear Environmental Eng 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

To be frank both Ever-Clear Environmental Eng's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Ever-Clear Environmental Eng to be really rather risky, as a result of its balance sheet health. 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. Case in point: We've spotted 3 warning signs for Ever-Clear Environmental Eng you should be aware of, and 1 of them is a bit unpleasant.

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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