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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, China Coal Xinji Energy Co.,Ltd (SHSE:601918) does carry debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

What Is China Coal Xinji EnergyLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 China Coal Xinji EnergyLtd had debt of CN¥18.4b, up from CN¥9.78b in one year. However, it also had CN¥2.38b in cash, and so its net debt is CN¥16.0b.

How Healthy Is China Coal Xinji EnergyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that China Coal Xinji EnergyLtd had liabilities of CN¥9.60b due within 12 months and liabilities of CN¥16.2b due beyond that. On the other hand, it had cash of CN¥2.38b and CN¥1.25b worth of receivables due within a year. So it has liabilities totalling CN¥22.2b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥20.8b, we think shareholders really should watch China Coal Xinji EnergyLtd's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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).

With net debt to EBITDA of 3.3 China Coal Xinji EnergyLtd has a fairly noticeable amount of debt. On the plus side, its EBIT was 9.2 times its interest expense, and its net debt to EBITDA, was quite high, at 3.3. Sadly, China Coal Xinji EnergyLtd's EBIT actually dropped 4.9% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Coal Xinji EnergyLtd's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, China Coal Xinji EnergyLtd created free cash flow amounting to 3.2% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, China Coal Xinji EnergyLtd's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that China Coal Xinji EnergyLtd's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example China Coal Xinji EnergyLtd has 3 warning signs (and 2 which are significant) we think 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.