Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Henan Shenhuo Coal & Power Co.,Ltd (SZSE:000933) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. 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 Henan Shenhuo Coal & PowerLtd

What Is Henan Shenhuo Coal & PowerLtd's Net Debt?

As you can see below, at the end of September 2023, Henan Shenhuo Coal & PowerLtd had CN¥26.8b of debt, up from CN¥20.5b a year ago. Click the image for more detail. However, it also had CN¥18.0b in cash, and so its net debt is CN¥8.80b.

How Healthy Is Henan Shenhuo Coal & PowerLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Henan Shenhuo Coal & PowerLtd had liabilities of CN¥32.7b due within 12 months and liabilities of CN¥5.54b due beyond that. Offsetting these obligations, it had cash of CN¥18.0b as well as receivables valued at CN¥1.81b due within 12 months. So its liabilities total CN¥18.5b 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 & PowerLtd has a market capitalization of CN¥37.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Henan Shenhuo Coal & PowerLtd has a low debt to EBITDA ratio of only 0.91. 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. In fact Henan Shenhuo Coal & PowerLtd's saving grace is its low debt levels, because its EBIT has tanked 36% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Henan Shenhuo Coal & PowerLtd's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Henan Shenhuo Coal & PowerLtd actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Henan Shenhuo Coal & PowerLtd's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Henan Shenhuo Coal & PowerLtd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Henan Shenhuo Coal & PowerLtd you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.