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.' 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 Yunnan Energy Investment Co., Ltd. (SZSE:002053) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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 Yunnan Energy Investment's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Yunnan Energy Investment had CN¥7.71b of debt, an increase on CN¥4.88b, over one year. However, it does have CN¥2.44b in cash offsetting this, leading to net debt of about CN¥5.27b.

How Healthy Is Yunnan Energy Investment's Balance Sheet?

The latest balance sheet data shows that Yunnan Energy Investment had liabilities of CN¥2.59b due within a year, and liabilities of CN¥7.03b falling due after that. Offsetting this, it had CN¥2.44b in cash and CN¥1.76b in receivables that were due within 12 months. So it has liabilities totalling CN¥5.42b more than its cash and near-term receivables, combined.

Yunnan Energy Investment has a market capitalization of CN¥9.73b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Yunnan Energy Investment has a debt to EBITDA ratio of 4.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 16.4 is very high, suggesting that the interest expense on the debt is currently quite low. It is well worth noting that Yunnan Energy Investment's EBIT shot up like bamboo after rain, gaining 51% in the last twelve months. That'll make it easier to manage its 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 Yunnan Energy Investment can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Yunnan Energy Investment 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

While Yunnan Energy Investment's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Yunnan Energy Investment is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Yunnan Energy Investment (of which 2 make us uncomfortable!) you should know about.

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.