Is Shanxi Lu'an Environmental Energy Development (SHSE:601699) 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.' 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 Shanxi Lu'an Environmental Energy Development Co., Ltd. (SHSE:601699) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Shanxi Lu'an Environmental Energy Development

What Is Shanxi Lu'an Environmental Energy Development's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Shanxi Lu'an Environmental Energy Development had CN¥19.9m of debt in September 2024, down from CN¥2.26b, one year before. However, its balance sheet shows it holds CN¥23.1b in cash, so it actually has CN¥23.1b net cash.

A Look At Shanxi Lu'an Environmental Energy Development's Liabilities

The latest balance sheet data shows that Shanxi Lu'an Environmental Energy Development had liabilities of CN¥36.4b due within a year, and liabilities of CN¥7.36b falling due after that. Offsetting these obligations, it had cash of CN¥23.1b as well as receivables valued at CN¥11.7b due within 12 months. So its liabilities total CN¥8.95b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Shanxi Lu'an Environmental Energy Development has a market capitalization of CN¥40.4b, 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. While it does have liabilities worth noting, Shanxi Lu'an Environmental Energy Development also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Shanxi Lu'an Environmental Energy Development if management cannot prevent a repeat of the 65% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shanxi Lu'an Environmental Energy Development's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shanxi Lu'an Environmental Energy Development has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Shanxi Lu'an Environmental Energy Development actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

Although Shanxi Lu'an Environmental Energy Development's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥23.1b. The cherry on top was that in converted 109% of that EBIT to free cash flow, bringing in CN¥2.9b. So we are not troubled with Shanxi Lu'an Environmental Energy Development's debt use. 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. For instance, we've identified 2 warning signs for Shanxi Lu'an Environmental Energy Development (1 is concerning) you should be aware of.

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.