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 China Three Gorges Renewables (Group) Co.,Ltd. (SHSE:600905) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

How Much Debt Does China Three Gorges Renewables (Group)Ltd Carry?

As you can see below, at the end of September 2024, China Three Gorges Renewables (Group)Ltd had CN¥176.1b of debt, up from CN¥143.0b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥8.95b, its net debt is less, at about CN¥167.2b.

How Strong Is China Three Gorges Renewables (Group)Ltd's Balance Sheet?

The latest balance sheet data shows that China Three Gorges Renewables (Group)Ltd had liabilities of CN¥53.0b due within a year, and liabilities of CN¥186.0b falling due after that. Offsetting these obligations, it had cash of CN¥8.95b as well as receivables valued at CN¥43.5b due within 12 months. So its liabilities total CN¥186.5b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's massive market capitalization of CN¥129.9b, we think shareholders really should watch China Three Gorges Renewables (Group)Ltd'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.

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 Three Gorges Renewables (Group)Ltd has a rather high debt to EBITDA ratio of 7.1 which suggests a meaningful debt load. However, its interest coverage of 3.5 is reasonably strong, which is a good sign. Fortunately, China Three Gorges Renewables (Group)Ltd grew its EBIT by 6.2% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Three Gorges Renewables (Group)Ltd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, China Three Gorges Renewables (Group)Ltd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both China Three Gorges Renewables (Group)Ltd's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. After considering the datapoints discussed, we think China Three Gorges Renewables (Group)Ltd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 instance, we've identified 2 warning signs for China Three Gorges Renewables (Group)Ltd (1 makes us a bit uncomfortable) you should be aware of.

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.