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. We can see that Weigang Environmental Technology Holding Group Limited (HKG:1845) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Weigang Environmental Technology Holding Group Carry?
As you can see below, at the end of June 2019, Weigang Environmental Technology Holding Group had CN¥16.9m of debt, up from CN¥10.0m a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥239.7m in cash, so it actually has CN¥222.8m net cash.
How Strong Is Weigang Environmental Technology Holding Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Weigang Environmental Technology Holding Group had liabilities of CN¥158.4m due within 12 months and liabilities of CN¥3.60m due beyond that. On the other hand, it had cash of CN¥239.7m and CN¥308.5m worth of receivables due within a year. So it actually has CN¥386.1m more liquid assets than total liabilities.
This surplus liquidity suggests that Weigang Environmental Technology Holding Group's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Simply put, the fact that Weigang Environmental Technology Holding Group has more cash than debt is arguably a good indication that it can manage its debt safely.
But the bad news is that Weigang Environmental Technology Holding Group has seen its EBIT plunge 20% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Weigang Environmental Technology Holding Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Weigang Environmental Technology Holding Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Weigang Environmental Technology Holding Group 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.
While it is always sensible to investigate a company's debt, in this case Weigang Environmental Technology Holding Group has CN¥223m in net cash and a decent-looking balance sheet. So we don't have any problem with Weigang Environmental Technology Holding Group's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Weigang Environmental Technology Holding Group, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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