David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Chongqing Sanfeng Environment Group Corp., Ltd. (SHSE:601827) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Chongqing Sanfeng Environment Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Chongqing Sanfeng Environment Group had CN¥9.04b of debt, an increase on CN¥8.67b, over one year. However, it does have CN¥2.71b in cash offsetting this, leading to net debt of about CN¥6.33b.

How Strong Is Chongqing Sanfeng Environment Group's Balance Sheet?

According to the last reported balance sheet, Chongqing Sanfeng Environment Group had liabilities of CN¥5.74b due within 12 months, and liabilities of CN¥8.39b due beyond 12 months. On the other hand, it had cash of CN¥2.71b and CN¥2.45b worth of receivables due within a year. So its liabilities total CN¥8.97b more than the combination of its cash and short-term receivables.

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 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).

Chongqing Sanfeng Environment Group's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 6.2 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Chongqing Sanfeng Environment Group saw its EBIT slide 2.5% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Chongqing Sanfeng Environment Group 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.

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. Looking at the most recent three years, Chongqing Sanfeng Environment Group recorded free cash flow of 22% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Chongqing Sanfeng Environment Group's level of total liabilities makes us cautious about it, its track record of converting EBIT to free cash flow is no better. At least its interest cover gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Chongqing Sanfeng Environment Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Chongqing Sanfeng Environment Group has 2 warning signs we think 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