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 Beijing Capital Eco-Environment Protection Group Co., Ltd. (SHSE:600008) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Beijing Capital Eco-Environment Protection Group's Net Debt?
As you can see below, Beijing Capital Eco-Environment Protection Group had CN¥49.2b of debt at September 2023, down from CN¥51.9b a year prior. However, it also had CN¥5.32b in cash, and so its net debt is CN¥43.8b.
How Strong Is Beijing Capital Eco-Environment Protection Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Beijing Capital Eco-Environment Protection Group had liabilities of CN¥26.6b due within 12 months and liabilities of CN¥40.4b due beyond that. Offsetting these obligations, it had cash of CN¥5.32b as well as receivables valued at CN¥18.0b due within 12 months. So its liabilities total CN¥43.7b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥21.0b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Beijing Capital Eco-Environment Protection 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a net debt to EBITDA ratio of 6.4, it's fair to say Beijing Capital Eco-Environment Protection Group does have a significant amount of debt. However, its interest coverage of 2.8 is reasonably strong, which is a good sign. Another concern for investors might be that Beijing Capital Eco-Environment Protection Group's EBIT fell 18% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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 Beijing Capital Eco-Environment Protection Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, Beijing Capital Eco-Environment Protection 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, Beijing Capital Eco-Environment Protection 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. And furthermore, its EBIT growth rate also fails to instill confidence. It's also worth noting that Beijing Capital Eco-Environment Protection Group is in the Water Utilities industry, which is often considered to be quite defensive. We think the chances that Beijing Capital Eco-Environment Protection Group has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Beijing Capital Eco-Environment Protection Group has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.