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Auditors Have Doubts About Chiho Environmental Group (HKG:976)

Simply Wall St ·  Jun 17, 2022 19:02

Unfortunately for shareholders, when Chiho Environmental Group Limited (HKG:976) reported results for the period to December 2021, its auditors, PricewaterhouseCoopers LLP, expressed uncertainty about whether it can continue as a going concern. This means that, based on the financial results to that date, the company arguably should raise capital, or otherwise strengthen the balance sheet, as soon as possible.

Since the company probably needs cash fairly quickly, it may be in a position where it has to accept whatever terms it can get. So it is suddenly extremely important to consider whether the company is taking too much risk on its balance sheet. The biggest concern we would have is the company's debt, since its lenders might force the company into administration if it cannot repay them.

View our latest analysis for Chiho Environmental Group

What Is Chiho Environmental Group's Net Debt?

The image below, which you can click on for greater detail, shows that Chiho Environmental Group had debt of HK$1.66b at the end of December 2021, a reduction from HK$2.30b over a year. However, because it has a cash reserve of HK$782.3m, its net debt is less, at about HK$879.6m.

SEHK:976 Debt to Equity History June 17th 2022

A Look At Chiho Environmental Group's Liabilities

According to the last reported balance sheet, Chiho Environmental Group had liabilities of HK$4.43b due within 12 months, and liabilities of HK$672.4m due beyond 12 months. Offsetting this, it had HK$782.3m in cash and HK$2.31b in receivables that were due within 12 months. So it has liabilities totalling HK$2.01b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's HK$1.62b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Looking at its net debt to EBITDA of 1.00 and interest cover of 2.8 times, it seems to us that Chiho Environmental Group is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Chiho Environmental Group made a loss at the EBIT level, last year, but improved that to positive EBIT of HK$643m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Chiho Environmental Group's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Looking at the most recent year, Chiho Environmental Group recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Chiho Environmental Group's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the bigger picture, it seems clear to us that Chiho Environmental Group's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. While some investors may specialize in these sort of situations, it's simply too risky and complicated for us to want to invest in a company after an auditor has expressed doubts about its ability to continue as a going concern. We prefer to invest in companies that ensure the balance sheet remains healthier than that. 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. To that end, you should be aware of the 1 warning sign we've spotted with Chiho Environmental Group .

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.

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