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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Henan Yuneng Holdings Co.,Ltd. (SZSE:001896) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Henan Yuneng HoldingsLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Henan Yuneng HoldingsLtd had CN¥21.8b of debt, an increase on CN¥18.7b, over one year. On the flip side, it has CN¥1.29b in cash leading to net debt of about CN¥20.5b.

How Strong Is Henan Yuneng HoldingsLtd's Balance Sheet?

The latest balance sheet data shows that Henan Yuneng HoldingsLtd had liabilities of CN¥12.7b due within a year, and liabilities of CN¥15.4b falling due after that. Offsetting these obligations, it had cash of CN¥1.29b as well as receivables valued at CN¥2.95b due within 12 months. So its liabilities total CN¥23.8b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥6.62b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Henan Yuneng HoldingsLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

As it happens Henan Yuneng HoldingsLtd has a fairly concerning net debt to EBITDA ratio of 14.7 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. We also note that Henan Yuneng HoldingsLtd improved its EBIT from a last year's loss to a positive CN¥16m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Henan Yuneng HoldingsLtd will need earnings to service that debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Henan Yuneng HoldingsLtd 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 Henan Yuneng HoldingsLtd'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 at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Henan Yuneng HoldingsLtd is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that Henan Yuneng HoldingsLtd'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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Henan Yuneng HoldingsLtd (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.