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 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. Importantly, Henan Senyuan Electric Co., Ltd. (SZSE:002358) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Henan Senyuan Electric's Debt?

The image below, which you can click on for greater detail, shows that Henan Senyuan Electric had debt of CN¥2.03b at the end of September 2024, a reduction from CN¥2.19b over a year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Henan Senyuan Electric's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Henan Senyuan Electric had liabilities of CN¥3.22b due within 12 months and liabilities of CN¥45.4m due beyond that. Offsetting this, it had CN¥34.3m in cash and CN¥3.58b in receivables that were due within 12 months. So it actually has CN¥349.5m more liquid assets than total liabilities.

This surplus suggests that Henan Senyuan Electric has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

With net debt to EBITDA of 4.2 Henan Senyuan Electric has a fairly noticeable amount of debt. On the plus side, its EBIT was 9.8 times its interest expense, and its net debt to EBITDA, was quite high, at 4.2. It is well worth noting that Henan Senyuan Electric's EBIT shot up like bamboo after rain, gaining 64% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Henan Senyuan Electric will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. In the last two years, Henan Senyuan Electric created free cash flow amounting to 13% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Happily, Henan Senyuan Electric's impressive EBIT growth rate implies it has the upper hand on its debt. But the stark truth is that we are concerned by its net debt to EBITDA. Looking at all the aforementioned factors together, it strikes us that Henan Senyuan Electric can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Henan Senyuan Electric that you should be aware of.

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.

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