Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Henan Shenhuo Coal Industry and Electricity Power Co. Ltd (SZSE:000933) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Henan Shenhuo Coal Industry and Electricity Power's Net Debt?

As you can see below, Henan Shenhuo Coal Industry and Electricity Power had CN¥18.6b of debt at September 2024, down from CN¥26.8b a year prior. However, it also had CN¥9.88b in cash, and so its net debt is CN¥8.69b.

How Strong Is Henan Shenhuo Coal Industry and Electricity Power's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Henan Shenhuo Coal Industry and Electricity Power had liabilities of CN¥25.1b due within 12 months and liabilities of CN¥4.86b due beyond that. On the other hand, it had cash of CN¥9.88b and CN¥2.18b worth of receivables due within a year. So its liabilities total CN¥17.9b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Henan Shenhuo Coal Industry and Electricity Power has a market capitalization of CN¥36.5b, 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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Henan Shenhuo Coal Industry and Electricity Power has net debt of just 1.0 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. But the bad news is that Henan Shenhuo Coal Industry and Electricity Power has seen its EBIT plunge 16% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Henan Shenhuo Coal Industry and Electricity Power can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Henan Shenhuo Coal Industry and Electricity Power actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Henan Shenhuo Coal Industry and Electricity Power's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. When we consider all the elements mentioned above, it seems to us that Henan Shenhuo Coal Industry and Electricity Power is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example - Henan Shenhuo Coal Industry and Electricity Power has 1 warning sign we think you should be aware of.

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.