These 4 Measures Indicate That China Nuclear Engineering (SHSE:601611) Is Using Debt In A Risky Way

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, China Nuclear Engineering Corporation Limited (SHSE:601611) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Nuclear Engineering

How Much Debt Does China Nuclear Engineering Carry?

As you can see below, at the end of June 2024, China Nuclear Engineering had CN¥83.9b of debt, up from CN¥75.9b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥16.0b, its net debt is less, at about CN¥67.9b.

A Look At China Nuclear Engineering's Liabilities

We can see from the most recent balance sheet that China Nuclear Engineering had liabilities of CN¥143.1b falling due within a year, and liabilities of CN¥43.9b due beyond that. Offsetting these obligations, it had cash of CN¥16.0b as well as receivables valued at CN¥119.8b due within 12 months. So its liabilities total CN¥51.2b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥26.3b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, China Nuclear Engineering 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.

China Nuclear Engineering has a rather high debt to EBITDA ratio of 8.0 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. Another concern for investors might be that China Nuclear Engineering's EBIT fell 11% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Nuclear Engineering'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, China Nuclear Engineering burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both China Nuclear Engineering'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. And even its EBIT growth rate fails to inspire much confidence. We think the chances that China Nuclear Engineering has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for China Nuclear Engineering you should be aware of, and 1 of them is potentially serious.

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.