David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Shaanxi Energy Investment Co., Ltd. (SZSE:001286) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Shaanxi Energy Investment's Net Debt?

As you can see below, Shaanxi Energy Investment had CN¥24.2b of debt at March 2024, down from CN¥26.7b a year prior. However, because it has a cash reserve of CN¥6.69b, its net debt is less, at about CN¥17.5b.

How Healthy Is Shaanxi Energy Investment's Balance Sheet?

The latest balance sheet data shows that Shaanxi Energy Investment had liabilities of CN¥13.3b due within a year, and liabilities of CN¥21.3b falling due after that. Offsetting this, it had CN¥6.69b in cash and CN¥1.91b in receivables that were due within 12 months. So it has liabilities totalling CN¥25.9b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥37.5b, so it does suggest shareholders should keep an eye on Shaanxi Energy Investment's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Shaanxi Energy Investment's net debt of 2.2 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. Sadly, Shaanxi Energy Investment's EBIT actually dropped 8.3% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Shaanxi Energy Investment'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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Shaanxi Energy Investment recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Even if we have reservations about how easily Shaanxi Energy Investment is capable of (not) growing its EBIT, its interest cover and conversion of EBIT to free cash flow make us think feel relatively unconcerned. Taking the abovementioned factors together we do think Shaanxi Energy Investment's debt poses some risks to the business. 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 be aware of the 2 warning signs we've spotted with Shaanxi Energy Investment .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.