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, Jiangsu United Water Technology Co.,Ltd. (SHSE:603291) does carry debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does Jiangsu United Water TechnologyLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Jiangsu United Water TechnologyLtd had CN¥902.2m of debt, an increase on CN¥857.9m, over one year. However, it does have CN¥196.6m in cash offsetting this, leading to net debt of about CN¥705.6m.

How Strong Is Jiangsu United Water TechnologyLtd's Balance Sheet?

We can see from the most recent balance sheet that Jiangsu United Water TechnologyLtd had liabilities of CN¥774.4m falling due within a year, and liabilities of CN¥1.16b due beyond that. Offsetting these obligations, it had cash of CN¥196.6m as well as receivables valued at CN¥430.0m due within 12 months. So it has liabilities totalling CN¥1.30b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Jiangsu United Water TechnologyLtd has a market capitalization of CN¥4.42b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Jiangsu United Water TechnologyLtd's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 5.2 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly, Jiangsu United Water TechnologyLtd's EBIT fell a jaw-dropping 20% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Jiangsu United Water TechnologyLtd 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Jiangsu United Water TechnologyLtd reported free cash flow worth 6.6% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Jiangsu United Water TechnologyLtd's EBIT growth rate was disappointing. But at least its interest cover is not so bad. It's also worth noting that Jiangsu United Water TechnologyLtd is in the Water Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Jiangsu United Water TechnologyLtd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 instance, we've identified 1 warning sign for Jiangsu United Water TechnologyLtd that you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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