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 Jiangxi Hongcheng Environment Co.,Ltd. (SHSE:600461) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Jiangxi Hongcheng EnvironmentLtd's Debt?

As you can see below, at the end of March 2024, Jiangxi Hongcheng EnvironmentLtd had CN¥7.73b of debt, up from CN¥7.37b a year ago. Click the image for more detail. However, it does have CN¥2.43b in cash offsetting this, leading to net debt of about CN¥5.30b.

A Look At Jiangxi Hongcheng EnvironmentLtd's Liabilities

According to the last reported balance sheet, Jiangxi Hongcheng EnvironmentLtd had liabilities of CN¥8.43b due within 12 months, and liabilities of CN¥5.54b due beyond 12 months. Offsetting this, it had CN¥2.43b in cash and CN¥2.67b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.87b.

This is a mountain of leverage relative to its market capitalization of CN¥14.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a debt to EBITDA ratio of 1.9, Jiangxi Hongcheng EnvironmentLtd uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.1 times its interest expenses harmonizes with that theme. One way Jiangxi Hongcheng EnvironmentLtd could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Jiangxi Hongcheng EnvironmentLtd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Jiangxi Hongcheng EnvironmentLtd created free cash flow amounting to 3.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Jiangxi Hongcheng EnvironmentLtd's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. We should also note that Water Utilities industry companies like Jiangxi Hongcheng EnvironmentLtd commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Jiangxi Hongcheng EnvironmentLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 3 warning signs for Jiangxi Hongcheng EnvironmentLtd that you should be aware of.

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.

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