Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Canvest Environmental Protection Group Company Limited (HKG:1381) makes use of debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Canvest Environmental Protection Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Canvest Environmental Protection Group had HK$4.13b of debt, an increase on HK$3.16b, over one year. However, because it has a cash reserve of HK$1.36b, its net debt is less, at about HK$2.77b.
How Strong Is Canvest Environmental Protection Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Canvest Environmental Protection Group had liabilities of HK$1.34b due within 12 months and liabilities of HK$4.29b due beyond that. Offsetting this, it had HK$1.36b in cash and HK$647.8m in receivables that were due within 12 months. So it has liabilities totalling HK$3.62b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Canvest Environmental Protection Group is worth HK$9.52b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Canvest Environmental Protection Group's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 5.9 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that Canvest Environmental Protection Group's EBIT shot up like bamboo after rain, gaining 31% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Canvest Environmental Protection Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Canvest Environmental Protection 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.
Canvest Environmental Protection Group's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. We think that Canvest Environmental Protection 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. Over time, share prices tend to follow earnings per share, so if you're interested in Canvest Environmental Protection Group, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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