The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Cec Environmental Protection Co.,Ltd (SZSE:300172) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Cec Environmental ProtectionLtd
What Is Cec Environmental ProtectionLtd's Debt?
As you can see below, at the end of March 2022, Cec Environmental ProtectionLtd had CN¥341.1m of debt, up from CN¥299.2m a year ago. Click the image for more detail. But on the other hand it also has CN¥626.8m in cash, leading to a CN¥285.7m net cash position.
How Strong Is Cec Environmental ProtectionLtd's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Cec Environmental ProtectionLtd had liabilities of CN¥702.1m due within 12 months and liabilities of CN¥346.1m due beyond that. Offsetting this, it had CN¥626.8m in cash and CN¥915.5m in receivables that were due within 12 months. So it actually has CN¥494.1m more liquid assets than total liabilities.
This surplus suggests that Cec Environmental ProtectionLtd has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Cec Environmental ProtectionLtd boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Cec Environmental ProtectionLtd if management cannot prevent a repeat of the 47% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Cec Environmental ProtectionLtd will need earnings to service that debt. 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. While Cec Environmental ProtectionLtd has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Cec Environmental ProtectionLtd recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Cec Environmental ProtectionLtd has net cash of CN¥285.7m, as well as more liquid assets than liabilities. So we are not troubled with Cec Environmental ProtectionLtd's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Cec Environmental ProtectionLtd , and understanding them should be part of your investment process.
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.
