Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Shaanxi Provincial Natural Gas Co.,Ltd (SZSE:002267) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Shaanxi Provincial Natural GasLtd's Debt?

The chart below, which you can click on for greater detail, shows that Shaanxi Provincial Natural GasLtd had CN¥3.08b in debt in March 2024; about the same as the year before. However, it does have CN¥1.03b in cash offsetting this, leading to net debt of about CN¥2.05b.

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

Zooming in on the latest balance sheet data, we can see that Shaanxi Provincial Natural GasLtd had liabilities of CN¥4.25b due within 12 months and liabilities of CN¥1.30b due beyond that. Offsetting these obligations, it had cash of CN¥1.03b as well as receivables valued at CN¥176.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥4.34b.

This deficit isn't so bad because Shaanxi Provincial Natural GasLtd is worth CN¥8.83b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Shaanxi Provincial Natural GasLtd's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 31.4 times, makes us even more comfortable. And we also note warmly that Shaanxi Provincial Natural GasLtd grew its EBIT by 11% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Shaanxi Provincial Natural GasLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Shaanxi Provincial Natural GasLtd's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Shaanxi Provincial Natural GasLtd's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. It's also worth noting that Shaanxi Provincial Natural GasLtd is in the Gas Utilities industry, which is often considered to be quite defensive. All these things considered, it appears that Shaanxi Provincial Natural GasLtd can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Shaanxi Provincial Natural GasLtd , 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.