Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Huaneng Lancang River Hydropower Inc. (SHSE:600025) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. 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.

How Much Debt Does Huaneng Lancang River Hydropower Carry?

As you can see below, at the end of March 2024, Huaneng Lancang River Hydropower had CN¥116.3b of debt, up from CN¥87.8b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Huaneng Lancang River Hydropower's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Huaneng Lancang River Hydropower had liabilities of CN¥30.5b due within 12 months and liabilities of CN¥94.2b due beyond that. On the other hand, it had cash of CN¥2.28b and CN¥2.87b worth of receivables due within a year. So it has liabilities totalling CN¥119.6b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of CN¥187.6b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Huaneng Lancang River Hydropower has a rather high debt to EBITDA ratio of 6.4 which suggests a meaningful debt load. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Importantly Huaneng Lancang River Hydropower's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Huaneng Lancang River Hydropower's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Huaneng Lancang River Hydropower recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Huaneng Lancang River Hydropower's net debt to EBITDA was disappointing. But at least its interest cover is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Huaneng Lancang River Hydropower stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Huaneng Lancang River Hydropower you should be aware of, and 1 of them is potentially serious.

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.