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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that CECEP Guozhen Environmental Protection Technology Co., Ltd. (SZSE:300388) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

How Much Debt Does CECEP Guozhen Environmental Protection Technology Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 CECEP Guozhen Environmental Protection Technology had CN¥8.75b of debt, an increase on CN¥8.28b, over one year. However, it does have CN¥1.14b in cash offsetting this, leading to net debt of about CN¥7.60b.

How Strong Is CECEP Guozhen Environmental Protection Technology's Balance Sheet?

The latest balance sheet data shows that CECEP Guozhen Environmental Protection Technology had liabilities of CN¥5.71b due within a year, and liabilities of CN¥6.22b falling due after that. Offsetting this, it had CN¥1.14b in cash and CN¥4.37b in receivables that were due within 12 months. So its liabilities total CN¥6.42b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CN¥5.30b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

With a net debt to EBITDA ratio of 6.2, it's fair to say CECEP Guozhen Environmental Protection Technology does have a significant amount of debt. However, its interest coverage of 3.4 is reasonably strong, which is a good sign. However, one redeeming factor is that CECEP Guozhen Environmental Protection Technology grew its EBIT at 16% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine CECEP Guozhen Environmental Protection Technology's ability to maintain a healthy balance sheet going forward. 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, CECEP Guozhen Environmental Protection Technology recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both CECEP Guozhen Environmental Protection Technology's conversion of EBIT to free cash flow and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider CECEP Guozhen Environmental Protection Technology 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for CECEP Guozhen Environmental Protection Technology (1 is significant!) that you should be aware of before investing here.

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.