Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, Inner Mongolia Yuan Xing Energy Company Limited (SZSE:000683) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

How Much Debt Does Inner Mongolia Yuan Xing Energy Carry?

You can click the graphic below for the historical numbers, but it shows that Inner Mongolia Yuan Xing Energy had CN¥9.06b of debt in September 2024, down from CN¥10.2b, one year before. However, because it has a cash reserve of CN¥2.96b, its net debt is less, at about CN¥6.10b.

How Healthy Is Inner Mongolia Yuan Xing Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Inner Mongolia Yuan Xing Energy had liabilities of CN¥9.16b due within 12 months and liabilities of CN¥6.08b due beyond that. Offsetting this, it had CN¥2.96b in cash and CN¥1.27b in receivables that were due within 12 months. So it has liabilities totalling CN¥11.0b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Inner Mongolia Yuan Xing Energy has a market capitalization of CN¥21.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Inner Mongolia Yuan Xing Energy has a low debt to EBITDA ratio of only 1.1. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. On top of that, Inner Mongolia Yuan Xing Energy grew its EBIT by 81% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Inner Mongolia Yuan Xing Energy 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Inner Mongolia Yuan Xing Energy reported free cash flow worth 9.3% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Inner Mongolia Yuan Xing Energy's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Inner Mongolia Yuan Xing Energy is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 3 warning signs we've spotted with Inner Mongolia Yuan Xing Energy .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.