The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that Inner Mongolia MengDian HuaNeng Thermal Power Corporation Limited (SHSE:600863) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Inner Mongolia MengDian HuaNeng Thermal Power Carry?

The image below, which you can click on for greater detail, shows that Inner Mongolia MengDian HuaNeng Thermal Power had debt of CN¥9.60b at the end of March 2024, a reduction from CN¥13.9b over a year. However, it also had CN¥1.56b in cash, and so its net debt is CN¥8.05b.

How Strong Is Inner Mongolia MengDian HuaNeng Thermal Power's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Inner Mongolia MengDian HuaNeng Thermal Power had liabilities of CN¥5.50b due within 12 months and liabilities of CN¥9.68b due beyond that. On the other hand, it had cash of CN¥1.56b and CN¥5.04b worth of receivables due within a year. So its liabilities total CN¥8.58b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Inner Mongolia MengDian HuaNeng Thermal Power is worth CN¥27.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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.

Inner Mongolia MengDian HuaNeng Thermal Power has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 22.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Inner Mongolia MengDian HuaNeng Thermal Power grew its EBIT by 2.6% in the last year, making that debt load look even more manageable. 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 Inner Mongolia MengDian HuaNeng Thermal 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.

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, Inner Mongolia MengDian HuaNeng Thermal Power 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

Inner Mongolia MengDian HuaNeng Thermal Power's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Inner Mongolia MengDian HuaNeng Thermal Power is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Inner Mongolia MengDian HuaNeng Thermal Power is showing 1 warning sign in our investment analysis , you should know about...

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.