Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Central Plains Environment Protection Co.,Ltd. (SZSE:000544) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Central Plains Environment ProtectionLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Central Plains Environment ProtectionLtd had CN¥21.1b of debt, an increase on CN¥15.9b, over one year. However, it does have CN¥1.71b in cash offsetting this, leading to net debt of about CN¥19.4b.

How Healthy Is Central Plains Environment ProtectionLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Central Plains Environment ProtectionLtd had liabilities of CN¥5.55b due within 12 months and liabilities of CN¥22.6b due beyond that. Offsetting these obligations, it had cash of CN¥1.71b as well as receivables valued at CN¥4.98b due within 12 months. So it has liabilities totalling CN¥21.4b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥7.51b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Central Plains Environment ProtectionLtd 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.

Weak interest cover of 2.4 times and a disturbingly high net debt to EBITDA ratio of 8.8 hit our confidence in Central Plains Environment ProtectionLtd like a one-two punch to the gut. The debt burden here is substantial. Looking on the bright side, Central Plains Environment ProtectionLtd boosted its EBIT by a silky 49% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Central Plains Environment ProtectionLtd 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Central Plains Environment ProtectionLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Central Plains Environment ProtectionLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Central Plains Environment ProtectionLtd's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 2 warning signs for Central Plains Environment ProtectionLtd (1 can't be ignored) you should be aware of.

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.

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.