We Think Henan Dayou Energy (SHSE:600403) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Henan Dayou Energy Co., Ltd (SHSE:600403) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Henan Dayou Energy

How Much Debt Does Henan Dayou Energy Carry?

The chart below, which you can click on for greater detail, shows that Henan Dayou Energy had CN¥5.92b in debt in September 2023; about the same as the year before. On the flip side, it has CN¥4.96b in cash leading to net debt of about CN¥960.6m.

How Strong Is Henan Dayou Energy's Balance Sheet?

According to the last reported balance sheet, Henan Dayou Energy had liabilities of CN¥11.3b due within 12 months, and liabilities of CN¥2.28b due beyond 12 months. On the other hand, it had cash of CN¥4.96b and CN¥1.06b worth of receivables due within a year. So its liabilities total CN¥7.60b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CN¥8.77b, so it does suggest shareholders should keep an eye on Henan Dayou Energy's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Henan Dayou Energy's low debt to EBITDA ratio of 0.54 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Henan Dayou Energy's EBIT fell a jaw-dropping 78% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Henan Dayou Energy's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Henan Dayou Energy actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Henan Dayou Energy's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Henan Dayou Energy is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 3 warning signs for Henan Dayou Energy you should be aware of, and 1 of them can't be ignored.

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.