Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, China Water Affairs Group Limited (HKG:855) does carry 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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.

What Is China Water Affairs Group's Debt?

As you can see below, China Water Affairs Group had HK$24.2b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have HK$5.76b in cash offsetting this, leading to net debt of about HK$18.4b.

How Healthy Is China Water Affairs Group's Balance Sheet?

According to the last reported balance sheet, China Water Affairs Group had liabilities of HK$20.9b due within 12 months, and liabilities of HK$19.0b due beyond 12 months. Offsetting these obligations, it had cash of HK$5.76b as well as receivables valued at HK$7.72b due within 12 months. So it has liabilities totalling HK$26.5b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$7.62b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Water Affairs Group would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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 3.5 China Water Affairs Group has a fairly noticeable amount of debt. But the high interest coverage of 7.6 suggests it can easily service that debt. China Water Affairs Group grew its EBIT by 8.4% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Water Affairs 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. During the last three years, China Water Affairs Group 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, China Water Affairs Group's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities 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. It's also worth noting that China Water Affairs Group is in the Water Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that China Water Affairs Group's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. 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 2 warning signs for China Water Affairs Group (of which 1 doesn'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.