Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that China Longyuan Power Group Corporation Limited (HKG:916) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is China Longyuan Power Group's Debt?

As you can see below, China Longyuan Power Group had CN¥103.3b of debt at March 2024, down from CN¥120.7b a year prior. However, it does have CN¥4.18b in cash offsetting this, leading to net debt of about CN¥99.1b.

How Strong Is China Longyuan Power Group's Balance Sheet?

We can see from the most recent balance sheet that China Longyuan Power Group had liabilities of CN¥72.3b falling due within a year, and liabilities of CN¥79.5b due beyond that. On the other hand, it had cash of CN¥4.18b and CN¥40.2b worth of receivables due within a year. So it has liabilities totalling CN¥107.5b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of CN¥107.8b, so it does suggest shareholders should keep an eye on China Longyuan Power Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Longyuan Power Group's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 4.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We saw China Longyuan Power Group grow its EBIT by 2.1% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Longyuan Power Group 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Longyuan Power Group recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Mulling over China Longyuan Power Group's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. We're quite clear that we consider China Longyuan Power Group to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. We've identified 2 warning signs with China Longyuan Power Group (at least 1 which is a bit unpleasant) , 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.