David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Shandong Xinchao Energy Corporation Limited (SHSE:600777) does use debt in its business. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Shandong Xinchao Energy

How Much Debt Does Shandong Xinchao Energy Carry?

The chart below, which you can click on for greater detail, shows that Shandong Xinchao Energy had CN¥8.27b in debt in September 2023; about the same as the year before. However, because it has a cash reserve of CN¥2.70b, its net debt is less, at about CN¥5.57b.

How Strong Is Shandong Xinchao Energy's Balance Sheet?

According to the last reported balance sheet, Shandong Xinchao Energy had liabilities of CN¥3.15b due within 12 months, and liabilities of CN¥12.2b due beyond 12 months. On the other hand, it had cash of CN¥2.70b and CN¥1.78b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥10.9b.

While this might seem like a lot, it is not so bad since Shandong Xinchao Energy has a market capitalization of CN¥19.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Shandong Xinchao Energy has a low net debt to EBITDA ratio of only 0.82. And its EBIT easily covers its interest expense, being 25.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Shandong Xinchao Energy saw its EBIT drop by 3.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Shandong Xinchao Energy will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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 most recent two years, Shandong Xinchao Energy recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Shandong Xinchao Energy's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that Shandong Xinchao Energy can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Over time, share prices tend to follow earnings per share, so if you're interested in Shandong Xinchao Energy, you may well want to click here to check an interactive graph of its earnings per share history.

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.