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.' 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. We can see that CHN Energy Changyuan Electric Power Co.,Ltd. (SZSE:000966) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 CHN Energy Changyuan Electric PowerLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 CHN Energy Changyuan Electric PowerLtd had CN¥22.8b of debt, an increase on CN¥17.9b, over one year. Net debt is about the same, since the it doesn't have much cash.

A Look At CHN Energy Changyuan Electric PowerLtd's Liabilities

We can see from the most recent balance sheet that CHN Energy Changyuan Electric PowerLtd had liabilities of CN¥10.6b falling due within a year, and liabilities of CN¥16.1b due beyond that. Offsetting this, it had CN¥299.5m in cash and CN¥1.78b in receivables that were due within 12 months. So its liabilities total CN¥24.6b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥12.9b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, CHN Energy Changyuan Electric PowerLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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

With a net debt to EBITDA ratio of 9.0, it's fair to say CHN Energy Changyuan Electric PowerLtd does have a significant amount of debt. However, its interest coverage of 2.5 is reasonably strong, which is a good sign. Looking on the bright side, CHN Energy Changyuan Electric PowerLtd boosted its EBIT by a silky 48% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since CHN Energy Changyuan Electric PowerLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, CHN Energy Changyuan 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, CHN Energy Changyuan 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 on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that CHN Energy Changyuan Electric PowerLtd's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for CHN Energy Changyuan Electric PowerLtd (2 can't be ignored) 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.