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.' 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 can see that Guanghui Energy Co., Ltd. (SHSE:600256) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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, 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 Guanghui Energy's Net Debt?

As you can see below, at the end of March 2024, Guanghui Energy had CN¥21.1b of debt, up from CN¥15.2b a year ago. Click the image for more detail. However, it also had CN¥6.29b in cash, and so its net debt is CN¥14.9b.

How Strong Is Guanghui Energy's Balance Sheet?

The latest balance sheet data shows that Guanghui Energy had liabilities of CN¥22.2b due within a year, and liabilities of CN¥9.29b falling due after that. Offsetting this, it had CN¥6.29b in cash and CN¥4.52b in receivables that were due within 12 months. So it has liabilities totalling CN¥20.7b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Guanghui Energy has a market capitalization of CN¥48.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Guanghui Energy's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 5.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Guanghui Energy's EBIT fell a jaw-dropping 66% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Guanghui Energy can strengthen its balance sheet over time. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Guanghui Energy produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Guanghui Energy's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to convert EBIT to free cash flow isn't too shabby at all. When we consider all the factors discussed, it seems to us that Guanghui Energy is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Guanghui Energy is showing 3 warning signs in our investment analysis , you should know about...

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 debt 100% free, right now.

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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.

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