Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Chongqing Three Gorges Water Conservancy and Electric Power Co., Ltd. (SHSE:600116) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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 think about a company's use of debt, we first look at cash and debt together.

What Is Chongqing Three Gorges Water Conservancy and Electric Power's Debt?

The image below, which you can click on for greater detail, shows that at March 2024 Chongqing Three Gorges Water Conservancy and Electric Power had debt of CN¥9.32b, up from CN¥8.10b in one year. On the flip side, it has CN¥1.94b in cash leading to net debt of about CN¥7.38b.

How Strong Is Chongqing Three Gorges Water Conservancy and Electric Power's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chongqing Three Gorges Water Conservancy and Electric Power had liabilities of CN¥7.72b due within 12 months and liabilities of CN¥4.85b due beyond that. On the other hand, it had cash of CN¥1.94b and CN¥2.44b worth of receivables due within a year. So its liabilities total CN¥8.19b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Chongqing Three Gorges Water Conservancy and Electric Power has a market capitalization of CN¥13.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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.

Chongqing Three Gorges Water Conservancy and Electric Power has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.0 times, suggesting it can responsibly service its obligations. Looking on the bright side, Chongqing Three Gorges Water Conservancy and Electric Power boosted its EBIT by a silky 47% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. 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 Chongqing Three Gorges Water Conservancy and Electric Power'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Chongqing Three Gorges Water Conservancy and Electric Power 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

Chongqing Three Gorges Water Conservancy and Electric Power's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Electric Utilities industry companies like Chongqing Three Gorges Water Conservancy and Electric Power commonly do use debt without problems. Taking the abovementioned factors together we do think Chongqing Three Gorges Water Conservancy and Electric Power's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Chongqing Three Gorges Water Conservancy and Electric Power (including 1 which is potentially serious) .

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.

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