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 Zheneng Jinjiang Environment Holding Company Limited (SGX:BWM) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Zheneng Jinjiang Environment Holding

How Much Debt Does Zheneng Jinjiang Environment Holding Carry?

The chart below, which you can click on for greater detail, shows that Zheneng Jinjiang Environment Holding had CN¥11.3b in debt in June 2023; about the same as the year before. However, because it has a cash reserve of CN¥379.4m, its net debt is less, at about CN¥10.9b.

How Healthy Is Zheneng Jinjiang Environment Holding's Balance Sheet?

According to the last reported balance sheet, Zheneng Jinjiang Environment Holding had liabilities of CN¥5.74b due within 12 months, and liabilities of CN¥8.64b due beyond 12 months. Offsetting these obligations, it had cash of CN¥379.4m as well as receivables valued at CN¥3.25b due within 12 months. So it has liabilities totalling CN¥10.8b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥1.56b 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'd watch its balance sheet closely, without a doubt. After all, Zheneng Jinjiang Environment Holding would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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 6.8, it's fair to say Zheneng Jinjiang Environment Holding does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that Zheneng Jinjiang Environment Holding grew its EBIT at 17% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Zheneng Jinjiang Environment Holding'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Zheneng Jinjiang Environment Holding burned a lot of cash. 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 Zheneng Jinjiang Environment Holding'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 on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Zheneng Jinjiang Environment Holding has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 3 warning signs for Zheneng Jinjiang Environment Holding that you should be aware of before investing here.

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. 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.