Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Sichuan Xichang Electric Power Co.,Ltd. (SHSE:600505) makes use of debt. But should shareholders be worried about its use of debt?

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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Sichuan Xichang Electric PowerLtd's Debt?

You can click the graphic below for the historical numbers, but it shows that Sichuan Xichang Electric PowerLtd had CN¥2.18b of debt in September 2024, down from CN¥2.34b, one year before. On the flip side, it has CN¥263.9m in cash leading to net debt of about CN¥1.92b.

How Healthy Is Sichuan Xichang Electric PowerLtd's Balance Sheet?

The latest balance sheet data shows that Sichuan Xichang Electric PowerLtd had liabilities of CN¥966.2m due within a year, and liabilities of CN¥2.01b falling due after that. On the other hand, it had cash of CN¥263.9m and CN¥278.5m worth of receivables due within a year. So it has liabilities totalling CN¥2.43b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Sichuan Xichang Electric PowerLtd has a market capitalization of CN¥4.50b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Weak interest cover of 0.88 times and a disturbingly high net debt to EBITDA ratio of 5.1 hit our confidence in Sichuan Xichang Electric PowerLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Sichuan Xichang Electric PowerLtd grew its EBIT at 18% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Sichuan Xichang Electric PowerLtd'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Sichuan Xichang Electric PowerLtd recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Sichuan Xichang Electric PowerLtd's interest cover was a real negative on this analysis, as was its net debt to EBITDA. But its conversion of EBIT to free cash flow was significantly redeeming. It's also worth noting that Sichuan Xichang Electric PowerLtd is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Sichuan Xichang Electric PowerLtd's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. We've identified 2 warning signs with Sichuan Xichang Electric PowerLtd , and understanding them should be part of your investment process.

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.