Is Shandong Xinchao Energy (SHSE:600777) A Risky Investment?

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 note that Shandong Xinchao Energy Corporation Limited (SHSE:600777) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Shandong Xinchao Energy

How Much Debt Does Shandong Xinchao Energy Carry?

The image below, which you can click on for greater detail, shows that Shandong Xinchao Energy had debt of CN¥5.15b at the end of September 2024, a reduction from CN¥8.05b over a year. However, it also had CN¥3.01b in cash, and so its net debt is CN¥2.14b.

How Strong Is Shandong Xinchao Energy's Balance Sheet?

According to the last reported balance sheet, Shandong Xinchao Energy had liabilities of CN¥2.71b due within 12 months, and liabilities of CN¥9.68b due beyond 12 months. On the other hand, it had cash of CN¥3.01b and CN¥1.12b worth of receivables due within a year. So its liabilities total CN¥8.26b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shandong Xinchao Energy has a market capitalization of CN¥13.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Shandong Xinchao Energy has net debt of just 0.31 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.3 times, which is more than adequate. But the bad news is that Shandong Xinchao Energy has seen its EBIT plunge 16% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Shandong Xinchao Energy will need earnings to service that debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Shandong Xinchao Energy recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Shandong Xinchao Energy's conversion of EBIT to free cash flow was a real positive on this analysis, as was its net debt to EBITDA. But truth be told its EBIT growth rate had us nibbling our nails. Considering this range of data points, we think Shandong Xinchao Energy is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Over time, share prices tend to follow earnings per share, so if you're interested in Shandong Xinchao Energy, you may well want to click here to check an interactive graph of its earnings per share history.

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.