China Southern Power Grid Energy Efficiency & Clean Energy (SZSE:003035) Seems To Be Using A Lot 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. 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?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt 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 Debt?

As you can see below, China Southern Power Grid Energy Efficiency & Clean Energy had CN¥8.07b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have CN¥1.12b in cash offsetting this, leading to net debt of about CN¥6.95b.

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

The latest balance sheet data shows that China Southern Power Grid Energy Efficiency & Clean Energy had liabilities of CN¥3.69b due within a year, and liabilities of CN¥8.55b falling due after that. Offsetting these obligations, it had cash of CN¥1.12b as well as receivables valued at CN¥3.02b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.10b.

While this might seem like a lot, it is not so bad since China Southern Power Grid Energy Efficiency & Clean Energy has a market capitalization of CN¥16.9b, 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.

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.

Weak interest cover of 2.0 times and a disturbingly high net debt to EBITDA ratio of 6.4 hit our confidence in China Southern Power Grid Energy Efficiency & Clean Energy like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, China Southern Power Grid Energy Efficiency & Clean Energy saw its EBIT tank 46% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, China Southern Power Grid Energy Efficiency & Clean Energy 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

On the face of it, China Southern Power Grid Energy Efficiency & Clean Energy'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. Having said that, its ability to handle its total liabilities isn't such a worry. After considering the datapoints discussed, we think China Southern Power Grid Energy Efficiency & Clean Energy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 China Southern Power Grid Energy Efficiency & Clean Energy (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.