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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that ZONBONG LANDSCAPE Environmental Limited (HKG:1855) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is ZONBONG LANDSCAPE Environmental's Debt?
The image below, which you can click on for greater detail, shows that ZONBONG LANDSCAPE Environmental had debt of CN¥806.2m at the end of December 2023, a reduction from CN¥1.05b over a year. However, it does have CN¥210.4m in cash offsetting this, leading to net debt of about CN¥595.8m.
How Healthy Is ZONBONG LANDSCAPE Environmental's Balance Sheet?
We can see from the most recent balance sheet that ZONBONG LANDSCAPE Environmental had liabilities of CN¥2.99b falling due within a year, and liabilities of CN¥91.7m due beyond that. Offsetting this, it had CN¥210.4m in cash and CN¥2.99b in receivables that were due within 12 months. So it actually has CN¥122.8m more liquid assets than total liabilities.
Having regard to ZONBONG LANDSCAPE Environmental's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the CN¥7.17b company is struggling for cash, we still think it's worth monitoring its balance sheet.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
ZONBONG LANDSCAPE Environmental has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.3 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, ZONBONG LANDSCAPE Environmental made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥251m in the last twelve months. 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 ZONBONG LANDSCAPE Environmental 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, ZONBONG LANDSCAPE Environmental generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Our View
The good news is that ZONBONG LANDSCAPE Environmental's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its interest cover. Taking all this data into account, it seems to us that ZONBONG LANDSCAPE Environmental takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. To that end, you should learn about the 2 warning signs we've spotted with ZONBONG LANDSCAPE Environmental (including 1 which is concerning) .
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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