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. As with many other companies Top Energy Company Ltd.Shanxi (SHSE:600780) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
How Much Debt Does Top Energy CompanyShanxi Carry?
You can click the graphic below for the historical numbers, but it shows that Top Energy CompanyShanxi had CN¥480.2m of debt in March 2024, down from CN¥564.2m, one year before. However, its balance sheet shows it holds CN¥2.27b in cash, so it actually has CN¥1.79b net cash.
How Strong Is Top Energy CompanyShanxi's Balance Sheet?
The latest balance sheet data shows that Top Energy CompanyShanxi had liabilities of CN¥2.04b due within a year, and liabilities of CN¥649.3m falling due after that. Offsetting this, it had CN¥2.27b in cash and CN¥864.4m in receivables that were due within 12 months. So it actually has CN¥439.1m more liquid assets than total liabilities.
This short term liquidity is a sign that Top Energy CompanyShanxi could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Top Energy CompanyShanxi boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that Top Energy CompanyShanxi's load is not too heavy, because its EBIT was down 33% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Top Energy CompanyShanxi 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. Top Energy CompanyShanxi may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Top Energy CompanyShanxi actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Summing Up
While it is always sensible to investigate a company's debt, in this case Top Energy CompanyShanxi has CN¥1.79b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 117% of that EBIT to free cash flow, bringing in CN¥337m. So we are not troubled with Top Energy CompanyShanxi's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Top Energy CompanyShanxi has 1 warning sign we think 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.
