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.' 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. As with many other companies Chongqing Water Group Co.,Ltd. (SHSE:601158) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Chongqing Water GroupLtd's Debt?
The image below, which you can click on for greater detail, shows that at September 2024 Chongqing Water GroupLtd had debt of CN¥10.6b, up from CN¥8.62b in one year. However, it does have CN¥1.43b in cash offsetting this, leading to net debt of about CN¥9.19b.
A Look At Chongqing Water GroupLtd's Liabilities
The latest balance sheet data shows that Chongqing Water GroupLtd had liabilities of CN¥8.04b due within a year, and liabilities of CN¥8.82b falling due after that. On the other hand, it had cash of CN¥1.43b and CN¥2.74b worth of receivables due within a year. So its liabilities total CN¥12.7b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Chongqing Water GroupLtd has a market capitalization of CN¥24.2b, 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.
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 Water GroupLtd's net debt is 4.3 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, Chongqing Water GroupLtd's EBIT fell a jaw-dropping 90% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Chongqing Water GroupLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Chongqing Water GroupLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
On the face of it, Chongqing Water GroupLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like Chongqing Water GroupLtd commonly do use debt without problems. Overall, we think it's fair to say that Chongqing Water GroupLtd has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Chongqing Water GroupLtd (of which 2 don't sit too well with us!) you should know about.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.
