Warren Buffett famously said, '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. As with many other companies Inner Mongolia Dian Tou Energy Corporation Limited (SZSE:002128) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Inner Mongolia Dian Tou Energy's Debt?

The image below, which you can click on for greater detail, shows that Inner Mongolia Dian Tou Energy had debt of CN¥8.16b at the end of September 2024, a reduction from CN¥8.69b over a year. However, it also had CN¥4.74b in cash, and so its net debt is CN¥3.41b.

How Healthy Is Inner Mongolia Dian Tou Energy's Balance Sheet?

We can see from the most recent balance sheet that Inner Mongolia Dian Tou Energy had liabilities of CN¥6.59b falling due within a year, and liabilities of CN¥8.37b due beyond that. Offsetting these obligations, it had cash of CN¥4.74b as well as receivables valued at CN¥4.42b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥5.80b.

Since publicly traded Inner Mongolia Dian Tou Energy shares are worth a total of CN¥44.2b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Inner Mongolia Dian Tou Energy has net debt of just 0.35 times EBITDA, suggesting it could ramp leverage without breaking a sweat. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. Another good sign is that Inner Mongolia Dian Tou Energy has been able to increase its EBIT by 29% in twelve months, making it easier to pay down 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 Inner Mongolia Dian Tou Energy'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Inner Mongolia Dian Tou Energy recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Inner Mongolia Dian Tou Energy's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Inner Mongolia Dian Tou Energy is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you're interested in Inner Mongolia Dian Tou Energy, you may well want to click here to check an interactive graph of its earnings per share history.

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.