Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Wuxi Huaguang Environment & Energy Group Co.,Ltd. (SHSE:600475) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
How Much Debt Does Wuxi Huaguang Environment & Energy GroupLtd Carry?
As you can see below, at the end of September 2023, Wuxi Huaguang Environment & Energy GroupLtd had CN¥7.25b of debt, up from CN¥4.22b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥3.49b, its net debt is less, at about CN¥3.76b.
A Look At Wuxi Huaguang Environment & Energy GroupLtd's Liabilities
The latest balance sheet data shows that Wuxi Huaguang Environment & Energy GroupLtd had liabilities of CN¥9.74b due within a year, and liabilities of CN¥6.23b falling due after that. Offsetting this, it had CN¥3.49b in cash and CN¥6.28b in receivables that were due within 12 months. So it has liabilities totalling CN¥6.20b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CN¥10.3b, so it does suggest shareholders should keep an eye on Wuxi Huaguang Environment & Energy GroupLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Wuxi Huaguang Environment & Energy GroupLtd's net debt is 2.9 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We note that Wuxi Huaguang Environment & Energy GroupLtd grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Wuxi Huaguang Environment & Energy GroupLtd'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Wuxi Huaguang Environment & Energy GroupLtd 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
Neither Wuxi Huaguang Environment & Energy GroupLtd's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We think that Wuxi Huaguang Environment & Energy GroupLtd's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Wuxi Huaguang Environment & Energy GroupLtd , and understanding them should be part of your investment process.
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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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.