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.' 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. Importantly, DaTang HuaYin Electric Power CO.,LTD (SHSE:600744) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is DaTang HuaYin Electric PowerLTD's Net Debt?

As you can see below, DaTang HuaYin Electric PowerLTD had CN¥16.4b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of CN¥955.9m, its net debt is less, at about CN¥15.5b.

How Healthy Is DaTang HuaYin Electric PowerLTD's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that DaTang HuaYin Electric PowerLTD had liabilities of CN¥8.06b due within 12 months and liabilities of CN¥14.3b due beyond that. Offsetting this, it had CN¥955.9m in cash and CN¥1.99b in receivables that were due within 12 months. So its liabilities total CN¥19.4b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥6.42b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, DaTang HuaYin Electric PowerLTD would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens DaTang HuaYin Electric PowerLTD has a fairly concerning net debt to EBITDA ratio of 10.8 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. We also note that DaTang HuaYin Electric PowerLTD improved its EBIT from a last year's loss to a positive CN¥337m. When analysing debt levels, the balance sheet is the obvious place to start. But it is DaTang HuaYin Electric PowerLTD's earnings that will influence how the balance sheet holds up in the future. 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 the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, DaTang HuaYin Electric PowerLTD burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, DaTang HuaYin Electric PowerLTD's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities 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. After considering the datapoints discussed, we think DaTang HuaYin Electric PowerLTD has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for DaTang HuaYin Electric PowerLTD you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.