Does Kunming Dianchi Water Treatment (HKG:3768) Use Too Much Debt?

David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, Kunming Dianchi Water Treatment Co., Ltd. (HKG:3768) is in debt. But should shareholders worry about its use of debt?

When is debt a problem?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check our latest analysis for Kunming Dianchi water treatment

What is Kunming Dianchi Water Treatment’s net debt?

You can click on the graph below for historical figures, but it shows that Kunming Dianchi Water Treatment had a debt of 5.65 billion yen in June 2022, compared to 5.90 billion yen a year before. However, he also had 769.7 million yen in cash, so his net debt is 4.88 billion yen.

SEHK: 3768 Historical Debt to Equity September 2, 2022

How healthy is Kunming Dianchi’s water treatment record?

The latest balance sheet data shows that Kunming Dianchi Water Treatment had liabilities of 3.54 billion yen maturing within one year, and liabilities of 3.19 billion yen maturing thereafter. In return, he had 769.7 million yen in cash and 3.02 billion yen in debt due within 12 months. It therefore has liabilities totaling 2.93 billion Canadian yen more than its cash and short-term receivables, combined.

The deficiency here weighs heavily on the company itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet. We would therefore be watching his balance sheet closely, no doubt. Ultimately, Kunming Dianchi Water Treatment would likely need a major recapitalization if its creditors were to demand repayment.

In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

Kunming Dianchi Water Treatment has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 3.9 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. On the bright side, Kunming Dianchi Water Treatment increased its EBIT by 72% last year. Like a mother’s loving embrace of a newborn, this kind of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is the profits of Kunming Dianchi Water Treatment that will influence the balance sheet in the future. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Kunming Dianchi Water Treatment has had substantial negative free cash flow, in total. While investors no doubt expect a reversal of this situation in due course, it clearly means that its use of debt is more risky.

Our point of view

To be frank, Kunming Dianchi Water Treatment’s EBIT to free cash flow conversion and track record of keeping its total liabilities under control makes us rather uncomfortable with its level of leverage. But on the bright side, its EBIT growth rate is a good sign and makes us more optimistic. It should also be noted that companies in the water utility sector like Kunming Dianchi Water Treatment generally use debt without problems. We are quite clear that we consider Kunming Dianchi’s water treatment to be quite risky indeed, due to the health of its balance sheet. For this reason, we are quite cautious about the stock and believe shareholders should keep a close eye on its liquidity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To this end, you should be aware of the 1 warning sign we spotted with Kunming Dianchi Water Treatment.

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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