Hunan Yuneng New Energy Battery MaterialLtd (SZSE:301358) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Hunan Yuneng New Energy Battery Material Co.,Ltd. (SZSE:301358) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Hunan Yuneng New Energy Battery MaterialLtd

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

As you can see below, Hunan Yuneng New Energy Battery MaterialLtd had CN¥5.43b of debt at March 2024, down from CN¥6.53b a year prior. However, because it has a cash reserve of CN¥1.44b, its net debt is less, at about CN¥4.00b.

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

We can see from the most recent balance sheet that Hunan Yuneng New Energy Battery MaterialLtd had liabilities of CN¥10.9b falling due within a year, and liabilities of CN¥3.80b due beyond that. On the other hand, it had cash of CN¥1.44b and CN¥8.44b worth of receivables due within a year. So its liabilities total CN¥4.80b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Hunan Yuneng New Energy Battery MaterialLtd has a market capitalization of CN¥18.5b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hunan Yuneng New Energy Battery MaterialLtd has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 10.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Hunan Yuneng New Energy Battery MaterialLtd if management cannot prevent a repeat of the 47% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hunan Yuneng New Energy Battery MaterialLtd can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Hunan Yuneng New Energy Battery MaterialLtd 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

On the face of it, Hunan Yuneng New Energy Battery MaterialLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Hunan Yuneng New Energy Battery MaterialLtd's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Be aware that Hunan Yuneng New Energy Battery MaterialLtd is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.