Is Henan Dayou Energy (SHSE:600403) 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.' 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. We can see that Henan Dayou Energy Co., Ltd (SHSE:600403) does use debt in its business. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Henan Dayou Energy

How Much Debt Does Henan Dayou Energy Carry?

You can click the graphic below for the historical numbers, but it shows that Henan Dayou Energy had CN¥5.58b of debt in September 2024, down from CN¥5.92b, one year before. However, because it has a cash reserve of CN¥5.00b, its net debt is less, at about CN¥573.7m.

How Strong Is Henan Dayou Energy's Balance Sheet?

We can see from the most recent balance sheet that Henan Dayou Energy had liabilities of CN¥11.3b falling due within a year, and liabilities of CN¥3.60b due beyond that. On the other hand, it had cash of CN¥5.00b and CN¥921.6m worth of receivables due within a year. So it has liabilities totalling CN¥9.00b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥8.27b, we think shareholders really should watch Henan Dayou Energy's debt levels, like a parent watching their child ride a bike for the first time. 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Henan Dayou Energy will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Henan Dayou Energy made a loss at the EBIT level, and saw its revenue drop to CN¥5.1b, which is a fall of 21%. To be frank that doesn't bode well.

Caveat Emptor

Not only did Henan Dayou Energy's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost CN¥716m at the EBIT level. When we look at that alongside the significant liabilities, we're not particularly confident about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it burned through CN¥698m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. 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. Be aware that Henan Dayou Energy is showing 1 warning sign in our investment analysis , 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.