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.' 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 note that Hunan Yuneng New Energy Battery Material Co.,Ltd. (SZSE:301358) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Hunan Yuneng New Energy Battery MaterialLtd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Hunan Yuneng New Energy Battery MaterialLtd had CN¥6.22b of debt, an increase on CN¥4.67b, over one year. However, it also had CN¥1.08b in cash, and so its net debt is CN¥5.14b.

How Healthy Is Hunan Yuneng New Energy Battery MaterialLtd's Balance Sheet?

According to the last reported balance sheet, Hunan Yuneng New Energy Battery MaterialLtd had liabilities of CN¥12.5b due within 12 months, and liabilities of CN¥3.51b due beyond 12 months. On the other hand, it had cash of CN¥1.08b and CN¥9.11b worth of receivables due within a year. So its liabilities total CN¥5.81b more than the combination of its cash and short-term receivables.

Given Hunan Yuneng New Energy Battery MaterialLtd has a market capitalization of CN¥38.3b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Hunan Yuneng New Energy Battery MaterialLtd's debt to EBITDA ratio (2.7) suggests that it uses some debt, its interest cover is very weak, at 2.5, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Hunan Yuneng New Energy Battery MaterialLtd saw its EBIT tank 87% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hunan Yuneng New Energy Battery MaterialLtd's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Hunan Yuneng New Energy Battery MaterialLtd 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 Hunan Yuneng New Energy Battery MaterialLtd's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, it seems to us that Hunan Yuneng New Energy Battery MaterialLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 5 warning signs for Hunan Yuneng New Energy Battery MaterialLtd (1 is potentially serious) you should be aware of.

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.