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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Hubei Energy Group Co., Ltd. (SZSE:000883) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Hubei Energy Group's Debt?

As you can see below, at the end of June 2024, Hubei Energy Group had CN¥40.9b of debt, up from CN¥35.7b a year ago. Click the image for more detail. On the flip side, it has CN¥2.22b in cash leading to net debt of about CN¥38.7b.

How Healthy Is Hubei Energy Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hubei Energy Group had liabilities of CN¥22.8b due within 12 months and liabilities of CN¥33.0b due beyond that. On the other hand, it had cash of CN¥2.22b and CN¥5.34b worth of receivables due within a year. So it has liabilities totalling CN¥48.2b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the CN¥30.9b 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, Hubei Energy Group would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Hubei Energy Group has a rather high debt to EBITDA ratio of 5.7 which suggests a meaningful debt load. However, its interest coverage of 4.8 is reasonably strong, which is a good sign. Notably, Hubei Energy Group's EBIT launched higher than Elon Musk, gaining a whopping 179% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hubei Energy Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Hubei Energy Group 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, Hubei Energy Group's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow 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. We're quite clear that we consider Hubei Energy Group to be really rather risky, as a result of its balance sheet health. 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. Case in point: We've spotted 2 warning signs for Hubei Energy Group you should be aware of, and 1 of them is significant.

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.