The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that China Water Affairs Group Limited (HKG:855) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for China Water Affairs Group

How Much Debt Does China Water Affairs Group Carry?

As you can see below, at the end of March 2022, China Water Affairs Group had HK$23.2b of debt, up from HK$19.1b a year ago. Click the image for more detail. However, it does have HK$7.17b in cash offsetting this, leading to net debt of about HK$16.0b.

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

We can see from the most recent balance sheet that China Water Affairs Group had liabilities of HK$19.2b falling due within a year, and liabilities of HK$17.3b due beyond that. Offsetting this, it had HK$7.17b in cash and HK$2.86b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$26.5b.

The deficiency here weighs heavily on the HK$11.7b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, China Water Affairs Group would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

China Water Affairs Group's net debt is 3.4 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 12.1 is very high, suggesting that the interest expense on the debt is currently quite low. One way China Water Affairs Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, China Water Affairs Group recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

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, we think it's fair to say that China Water Affairs Group 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. To that end, you should learn about the 3 warning signs we've spotted with China Water Affairs Group (including 1 which doesn't sit too well with us) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.