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.' 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. We can see that Shanxi Guoxin Energy Corporation Limited (SHSE:600617) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Shanxi Guoxin Energy
What Is Shanxi Guoxin Energy's Net Debt?
As you can see below, Shanxi Guoxin Energy had CN¥18.9b of debt at September 2024, down from CN¥21.2b a year prior. However, it also had CN¥2.65b in cash, and so its net debt is CN¥16.3b.
A Look At Shanxi Guoxin Energy's Liabilities
We can see from the most recent balance sheet that Shanxi Guoxin Energy had liabilities of CN¥7.56b falling due within a year, and liabilities of CN¥15.7b due beyond that. Offsetting these obligations, it had cash of CN¥2.65b as well as receivables valued at CN¥1.75b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥18.9b.
The deficiency here weighs heavily on the CN¥5.26b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Shanxi Guoxin Energy would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.68 times and a disturbingly high net debt to EBITDA ratio of 10.0 hit our confidence in Shanxi Guoxin Energy like a one-two punch to the gut. The debt burden here is substantial. Worse, Shanxi Guoxin Energy's EBIT was down 33% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Shanxi Guoxin Energy's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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, Shanxi Guoxin Energy actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
To be frank both Shanxi Guoxin Energy's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Shanxi Guoxin Energy has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Shanxi Guoxin Energy (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
About SHSE:600617
Shanxi Guoxin Energy
Engages natural gas development and utilization, and consulting services.
Proven track record second-rate dividend payer.