Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that Wangneng Environment Co.,Ltd (SZSE:002034) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

What Is Wangneng EnvironmentLtd's Net Debt?

The chart below, which you can click on for greater detail, shows that Wangneng EnvironmentLtd had CN¥5.99b in debt in June 2024; about the same as the year before. On the flip side, it has CN¥617.3m in cash leading to net debt of about CN¥5.37b.

How Strong Is Wangneng EnvironmentLtd's Balance Sheet?

According to the last reported balance sheet, Wangneng EnvironmentLtd had liabilities of CN¥2.23b due within 12 months, and liabilities of CN¥5.77b due beyond 12 months. Offsetting this, it had CN¥617.3m in cash and CN¥1.68b in receivables that were due within 12 months. So it has liabilities totalling CN¥5.70b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥6.14b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Wangneng EnvironmentLtd has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 3.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Investors should also be troubled by the fact that Wangneng EnvironmentLtd saw its EBIT drop by 16% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Wangneng EnvironmentLtd 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. In the last three years, Wangneng EnvironmentLtd created free cash flow amounting to 19% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over Wangneng EnvironmentLtd's attempt at (not) growing its EBIT, we're certainly not enthusiastic. And even its net debt to EBITDA fails to inspire much confidence. We're quite clear that we consider Wangneng EnvironmentLtd to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 instance, we've identified 2 warning signs for Wangneng EnvironmentLtd that you should be aware of.

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.