Shan Xi Hua Yang Group New EnergyLtd (SHSE:600348) Takes On Some Risk With Its Use Of Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Shan Xi Hua Yang Group New Energy Co.,Ltd. (SHSE:600348) 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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Shan Xi Hua Yang Group New EnergyLtd

What Is Shan Xi Hua Yang Group New EnergyLtd's Debt?

The image below, which you can click on for greater detail, shows that at September 2024 Shan Xi Hua Yang Group New EnergyLtd had debt of CN¥23.8b, up from CN¥19.4b in one year. However, it also had CN¥10.6b in cash, and so its net debt is CN¥13.2b.

How Healthy Is Shan Xi Hua Yang Group New EnergyLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shan Xi Hua Yang Group New EnergyLtd had liabilities of CN¥20.7b due within 12 months and liabilities of CN¥21.1b due beyond that. On the other hand, it had cash of CN¥10.6b and CN¥2.29b worth of receivables due within a year. So it has liabilities totalling CN¥28.9b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CN¥27.1b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Shan Xi Hua Yang Group New EnergyLtd's moderate net debt to EBITDA ratio ( being 1.9), indicates prudence when it comes to debt. And its strong interest cover of 11.0 times, makes us even more comfortable. Shareholders should be aware that Shan Xi Hua Yang Group New EnergyLtd's EBIT was down 57% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Shan Xi Hua Yang Group New EnergyLtd can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Shan Xi Hua Yang Group New EnergyLtd actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Mulling over Shan Xi Hua Yang Group New EnergyLtd's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider Shan Xi Hua Yang Group New EnergyLtd to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. 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 3 warning signs for Shan Xi Hua Yang Group New EnergyLtd (of which 2 make us uncomfortable!) you should know about.

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.