Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Chengdu Xingrong Environment Co., Ltd. (SZSE:000598) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Chengdu Xingrong Environment's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Chengdu Xingrong Environment had CN¥19.1b of debt, an increase on CN¥10.7b, over one year. On the flip side, it has CN¥5.42b in cash leading to net debt of about CN¥13.7b.

How Healthy Is Chengdu Xingrong Environment's Balance Sheet?

We can see from the most recent balance sheet that Chengdu Xingrong Environment had liabilities of CN¥8.90b falling due within a year, and liabilities of CN¥18.8b due beyond that. On the other hand, it had cash of CN¥5.42b and CN¥3.63b worth of receivables due within a year. So its liabilities total CN¥18.6b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥22.0b, so it does suggest shareholders should keep an eye on Chengdu Xingrong Environment's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Chengdu Xingrong Environment has net debt to EBITDA of 3.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.6. One way Chengdu Xingrong Environment could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Chengdu Xingrong Environment 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Chengdu Xingrong Environment 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

Mulling over Chengdu Xingrong Environment's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like Chengdu Xingrong Environment commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Chengdu Xingrong Environment stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 2 warning signs for Chengdu Xingrong Environment (1 can't be ignored!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com