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.' 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, DaTang HuaYin Electric Power CO.,LTD (SHSE:600744) does carry debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 DaTang HuaYin Electric PowerLTD's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 DaTang HuaYin Electric PowerLTD had CN¥20.1b of debt, an increase on CN¥17.6b, over one year. However, it also had CN¥1.30b in cash, and so its net debt is CN¥18.8b.

How Strong Is DaTang HuaYin Electric PowerLTD's Balance Sheet?

The latest balance sheet data shows that DaTang HuaYin Electric PowerLTD had liabilities of CN¥8.33b due within a year, and liabilities of CN¥14.3b falling due after that. Offsetting this, it had CN¥1.30b in cash and CN¥1.69b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥19.6b.

This deficit casts a shadow over the CN¥6.93b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, DaTang HuaYin Electric PowerLTD would likely require a major re-capitalisation if it had to pay its creditors today.

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

DaTang HuaYin Electric PowerLTD shareholders face the double whammy of a high net debt to EBITDA ratio (13.3), and fairly weak interest coverage, since EBIT is just 0.75 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that DaTang HuaYin Electric PowerLTD achieved a positive EBIT of CN¥277m 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 you can't view debt in total isolation; since DaTang HuaYin Electric PowerLTD will need earnings to service that debt. 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. Over the last year, DaTang HuaYin Electric PowerLTD saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both DaTang HuaYin Electric PowerLTD'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. Considering all the factors previously mentioned, we think that DaTang HuaYin Electric PowerLTD really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with DaTang HuaYin Electric PowerLTD (including 1 which can't be ignored) .

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.