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. As with many other companies Henan Yuneng Holdings Co.,Ltd. (SZSE:001896) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Henan Yuneng HoldingsLtd's Debt?

As you can see below, at the end of June 2024, Henan Yuneng HoldingsLtd had CN¥23.0b of debt, up from CN¥19.7b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥2.03b, its net debt is less, at about CN¥20.9b.

How Healthy Is Henan Yuneng HoldingsLtd's Balance Sheet?

The latest balance sheet data shows that Henan Yuneng HoldingsLtd had liabilities of CN¥12.3b due within a year, and liabilities of CN¥16.2b falling due after that. Offsetting this, it had CN¥2.03b in cash and CN¥2.23b in receivables that were due within 12 months. So its liabilities total CN¥24.3b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥5.54b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Henan Yuneng HoldingsLtd would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Henan Yuneng HoldingsLtd shareholders face the double whammy of a high net debt to EBITDA ratio (10.4), and fairly weak interest coverage, since EBIT is just 0.88 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Henan Yuneng HoldingsLtd achieved a positive EBIT of CN¥655m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Henan Yuneng HoldingsLtd'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Henan Yuneng HoldingsLtd burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Henan Yuneng HoldingsLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It's also worth noting that Henan Yuneng HoldingsLtd is in the Electric Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think Henan Yuneng HoldingsLtd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Henan Yuneng HoldingsLtd you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.