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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hangzhou Cogeneration Group Co., Ltd. (SHSE:605011) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

What Is Hangzhou Cogeneration Group's Debt?

As you can see below, Hangzhou Cogeneration Group had CN¥700.1m of debt at June 2024, down from CN¥846.5m a year prior. However, it does have CN¥668.6m in cash offsetting this, leading to net debt of about CN¥31.5m.

How Strong Is Hangzhou Cogeneration Group's Balance Sheet?

We can see from the most recent balance sheet that Hangzhou Cogeneration Group had liabilities of CN¥795.2m falling due within a year, and liabilities of CN¥367.0m due beyond that. Offsetting this, it had CN¥668.6m in cash and CN¥417.2m in receivables that were due within 12 months. So it has liabilities totalling CN¥76.3m more than its cash and near-term receivables, combined.

Having regard to Hangzhou Cogeneration Group's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥8.08b company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, Hangzhou Cogeneration Group has a very light debt load indeed.

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.

Hangzhou Cogeneration Group has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.089. Happily, it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt as easily as enthusiastic spray-tanners take on an orange hue. The good news is that Hangzhou Cogeneration Group has increased its EBIT by 7.8% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hangzhou Cogeneration Group will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Hangzhou Cogeneration Group recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that Hangzhou Cogeneration Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We would also note that Electric Utilities industry companies like Hangzhou Cogeneration Group commonly do use debt without problems. Considering this range of factors, it seems to us that Hangzhou Cogeneration Group is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Hangzhou Cogeneration Group (1 is a bit concerning!) 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.