Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Huaneng Lancang River Hydropower Inc. (SHSE:600025) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Huaneng Lancang River Hydropower Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Huaneng Lancang River Hydropower had CN¥119.5b of debt, an increase on CN¥91.3b, over one year. And it doesn't have much cash, so its net debt is about the same.

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

We can see from the most recent balance sheet that Huaneng Lancang River Hydropower had liabilities of CN¥33.0b falling due within a year, and liabilities of CN¥96.5b due beyond that. Offsetting this, it had CN¥2.02b in cash and CN¥4.82b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥122.7b.

This deficit is considerable relative to its very significant market capitalization of CN¥196.2b, so it does suggest shareholders should keep an eye on Huaneng Lancang River Hydropower'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). 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).

Huaneng Lancang River Hydropower has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.3 times, suggesting it can responsibly service its obligations. One way Huaneng Lancang River Hydropower could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Huaneng Lancang River Hydropower 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Huaneng Lancang River Hydropower recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Huaneng Lancang River Hydropower's struggle handle its debt, based on its EBITDA, 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 grow its EBIT isn't too shabby at all. Taking the abovementioned factors together we do think Huaneng Lancang River Hydropower's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 2 warning signs for Huaneng Lancang River Hydropower (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.