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.' 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. Importantly, Shaanxi Provincial Natural Gas Co.,Ltd (SZSE:002267) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Shaanxi Provincial Natural GasLtd

What Is Shaanxi Provincial Natural GasLtd's Net Debt?

The chart below, which you can click on for greater detail, shows that Shaanxi Provincial Natural GasLtd had CN¥2.66b in debt in June 2023; about the same as the year before. On the flip side, it has CN¥1.14b in cash leading to net debt of about CN¥1.52b.

How Strong Is Shaanxi Provincial Natural GasLtd's Balance Sheet?

According to the last reported balance sheet, Shaanxi Provincial Natural GasLtd had liabilities of CN¥5.12b due within 12 months, and liabilities of CN¥961.1m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.14b as well as receivables valued at CN¥226.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.71b.

This deficit is considerable relative to its market capitalization of CN¥7.72b, so it does suggest shareholders should keep an eye on Shaanxi Provincial Natural GasLtd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Shaanxi Provincial Natural GasLtd's net debt is only 1.5 times its EBITDA. And its EBIT covers its interest expense a whopping 14.4 times over. So we're pretty relaxed about its super-conservative use of debt. In fact Shaanxi Provincial Natural GasLtd's saving grace is its low debt levels, because its EBIT has tanked 41% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shaanxi Provincial Natural GasLtd'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Shaanxi Provincial Natural GasLtd's free cash flow amounted to 45% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Shaanxi Provincial Natural GasLtd's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We should also note that Gas Utilities industry companies like Shaanxi Provincial Natural GasLtd commonly do use debt without problems. Taking the abovementioned factors together we do think Shaanxi Provincial Natural GasLtd's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Shaanxi Provincial Natural GasLtd (1 can't be ignored) you should be aware of.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.