China Southern Power Grid Energy Efficiency & Clean Energy (SZSE:003035) Use Of Debt Could Be Considered Risky

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 China Southern Power Grid Energy Efficiency & Clean Energy Co., Ltd. (SZSE:003035) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Southern Power Grid Energy Efficiency & Clean Energy

What Is China Southern Power Grid Energy Efficiency & Clean Energy's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 China Southern Power Grid Energy Efficiency & Clean Energy had CN¥8.52b of debt, an increase on CN¥5.95b, over one year. On the flip side, it has CN¥1.17b in cash leading to net debt of about CN¥7.35b.

How Strong Is China Southern Power Grid Energy Efficiency & Clean Energy's Balance Sheet?

According to the last reported balance sheet, China Southern Power Grid Energy Efficiency & Clean Energy had liabilities of CN¥4.03b due within 12 months, and liabilities of CN¥7.51b due beyond 12 months. On the other hand, it had cash of CN¥1.17b and CN¥3.01b worth of receivables due within a year. So its liabilities total CN¥7.37b more than the combination of its cash and short-term receivables.

China Southern Power Grid Energy Efficiency & Clean Energy has a market capitalization of CN¥15.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Southern Power Grid Energy Efficiency & Clean Energy has a rather high debt to EBITDA ratio of 5.7 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.2 times, suggesting it can responsibly service its obligations. Another concern for investors might be that China Southern Power Grid Energy Efficiency & Clean Energy's EBIT fell 18% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Southern Power Grid Energy Efficiency & Clean 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, China Southern Power Grid Energy Efficiency & Clean Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both China Southern Power Grid Energy Efficiency & Clean Energy's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. We're quite clear that we consider China Southern Power Grid Energy Efficiency & Clean Energy to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for China Southern Power Grid Energy Efficiency & Clean Energy (of which 1 is concerning!) 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.