Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Beijing Enterprises Environment Group Limited (HKG:154) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Beijing Enterprises Environment Group's Net Debt?
The image below, which you can click on for greater detail, shows that Beijing Enterprises Environment Group had debt of HK$3.14b at the end of June 2019, a reduction from HK$3.81b over a year. On the flip side, it has HK$1.35b in cash leading to net debt of about HK$1.79b.
SEHK:154 Historical Debt, September 15th 2019
How Healthy Is Beijing Enterprises Environment Group's Balance Sheet?
The latest balance sheet data shows that Beijing Enterprises Environment Group had liabilities of HK$2.43b due within a year, and liabilities of HK$3.41b falling due after that. On the other hand, it had cash of HK$1.35b and HK$474.5m worth of receivables due within a year. So its liabilities total HK$4.02b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$1.10b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Beijing Enterprises Environment Group 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.
Beijing Enterprises Environment Group has a debt to EBITDA ratio of 3.4, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 10.9 times its interest expense, implying the company isn't really paying full freight on that debt. Even if not sustainable, that is a good sign. Unfortunately, Beijing Enterprises Environment Group saw its EBIT slide 2.7% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is Beijing Enterprises Environment 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Beijing Enterprises Environment 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
To be frank both Beijing Enterprises Environment Group'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 interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that Beijing Enterprises Environment Group'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. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Beijing Enterprises Environment Group's earnings per share history for free.
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 debt100% free, right now.
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