Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Chengdu Xingrong Environment Co., Ltd. (SZSE:000598) does use debt in its business. 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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Chengdu Xingrong Environment's Debt?

As you can see below, at the end of September 2024, Chengdu Xingrong Environment had CN¥18.9b of debt, up from CN¥11.9b a year ago. Click the image for more detail. However, it also had CN¥4.50b in cash, and so its net debt is CN¥14.5b.

How Healthy Is Chengdu Xingrong Environment's Balance Sheet?

We can see from the most recent balance sheet that Chengdu Xingrong Environment had liabilities of CN¥8.74b falling due within a year, and liabilities of CN¥19.2b due beyond that. On the other hand, it had cash of CN¥4.50b and CN¥3.84b worth of receivables due within a year. So it has liabilities totalling CN¥19.6b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥22.0b, so it does suggest shareholders should keep an eye on Chengdu Xingrong Environment's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

With net debt to EBITDA of 3.6 Chengdu Xingrong Environment has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.1 times its interest expense, and its net debt to EBITDA, was quite high, at 3.6. One way Chengdu Xingrong Environment could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, 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 future earnings, more than anything, that will determine Chengdu Xingrong Environment's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Chengdu Xingrong Environment saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We'd go so far as to say Chengdu Xingrong Environment's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Chengdu Xingrong Environment is in the Water Utilities industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Chengdu Xingrong Environment stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Chengdu Xingrong Environment (including 1 which doesn't sit too well with us) .

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.

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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.