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.' 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 China Energy Engineering Corporation Limited (HKG:3996) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does China Energy Engineering Carry?
As you can see below, at the end of December 2023, China Energy Engineering had CN¥235.4b of debt, up from CN¥190.8b a year ago. Click the image for more detail. On the flip side, it has CN¥77.7b in cash leading to net debt of about CN¥157.7b.
How Strong Is China Energy Engineering's Balance Sheet?
The latest balance sheet data shows that China Energy Engineering had liabilities of CN¥417.0b due within a year, and liabilities of CN¥177.9b falling due after that. On the other hand, it had cash of CN¥77.7b and CN¥230.7b worth of receivables due within a year. So it has liabilities totalling CN¥286.5b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the CN¥78.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, China Energy Engineering would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
With a net debt to EBITDA ratio of 6.4, it's fair to say China Energy Engineering does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.2 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that China Energy Engineering grew its EBIT at 13% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Energy Engineering's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Energy Engineering 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 Energy Engineering'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 at least it's pretty decent at growing its EBIT; that's encouraging. After considering the datapoints discussed, we think China Energy Engineering has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example China Energy Engineering has 2 warning signs (and 1 which can't be ignored) we think you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.