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.' 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. We note that Huadian Liaoning Energy Development Co.,Ltd (SHSE:600396) does have debt on its balance sheet. 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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Huadian Liaoning Energy DevelopmentLtd Carry?

The image below, which you can click on for greater detail, shows that Huadian Liaoning Energy DevelopmentLtd had debt of CN¥11.7b at the end of March 2024, a reduction from CN¥19.0b over a year. However, it does have CN¥496.3m in cash offsetting this, leading to net debt of about CN¥11.2b.

How Healthy Is Huadian Liaoning Energy DevelopmentLtd's Balance Sheet?

According to the last reported balance sheet, Huadian Liaoning Energy DevelopmentLtd had liabilities of CN¥7.23b due within 12 months, and liabilities of CN¥5.41b due beyond 12 months. Offsetting this, it had CN¥496.3m in cash and CN¥1.05b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥11.1b.

The deficiency here weighs heavily on the CN¥3.81b 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. At the end of the day, Huadian Liaoning Energy DevelopmentLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Strangely Huadian Liaoning Energy DevelopmentLtd has a sky high EBITDA ratio of 11.6, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably, Huadian Liaoning Energy DevelopmentLtd made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥107m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Huadian Liaoning Energy DevelopmentLtd's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Huadian Liaoning Energy DevelopmentLtd 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

While Huadian Liaoning Energy DevelopmentLtd's level of total liabilities has us nervous. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. We should also note that Electric Utilities industry companies like Huadian Liaoning Energy DevelopmentLtd commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Huadian Liaoning Energy DevelopmentLtd is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Huadian Liaoning Energy DevelopmentLtd (including 1 which makes us a bit uncomfortable) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com