Does China Water Industry Group (HKG:1129) Have A Healthy Balance Sheet?
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.' 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. As with many other companies China Water Industry Group Limited (HKG:1129) makes use of debt. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for China Water Industry Group
How Much Debt Does China Water Industry Group Carry?
As you can see below, China Water Industry Group had HK$756.6m of debt, at December 2018, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has HK$743.2m in cash leading to net debt of about HK$13.5m.
How Strong Is China Water Industry Group's Balance Sheet?
We can see from the most recent balance sheet that China Water Industry Group had liabilities of HK$955.8m falling due within a year, and liabilities of HK$842.5m due beyond that. Offsetting this, it had HK$743.2m in cash and HK$391.8m in receivables that were due within 12 months. So it has liabilities totalling HK$663.4m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of HK$798.3m, so it does suggest shareholders should keep an eye on China Water Industry Group's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
China Water Industry Group has very modest net debt, giving rise to a debt to EBITDA ratio of 0.044. And this impression is enhanced by its strong EBIT which covers interest costs 7.1 times. In addition to that, we're happy to report that China Water Industry Group has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is China Water Industry 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, China Water Industry Group burned a lot of cash. 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
Neither China Water Industry Group'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 EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Water Utilities industry companies like China Water Industry Group commonly do use debt without problems. We think that China Water Industry Group's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
