We Think LIAONING ENERGY INDUSTRYLTD (SHSE:600758) Is Taking Some Risk With Its Debt

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. As with many other companies LIAONING ENERGY INDUSTRY Co.,LTD (SHSE:600758) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for LIAONING ENERGY INDUSTRYLTD

What Is LIAONING ENERGY INDUSTRYLTD's Net Debt?

As you can see below, LIAONING ENERGY INDUSTRYLTD had CN¥4.06b of debt at September 2023, down from CN¥4.95b a year prior. However, because it has a cash reserve of CN¥2.29b, its net debt is less, at about CN¥1.77b.

How Strong Is LIAONING ENERGY INDUSTRYLTD's Balance Sheet?

We can see from the most recent balance sheet that LIAONING ENERGY INDUSTRYLTD had liabilities of CN¥7.04b falling due within a year, and liabilities of CN¥1.03b due beyond that. Offsetting this, it had CN¥2.29b in cash and CN¥1.53b in receivables that were due within 12 months. So it has liabilities totalling CN¥4.26b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥4.30b, so it does suggest shareholders should keep an eye on LIAONING ENERGY INDUSTRYLTD's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Given net debt is only 1.5 times EBITDA, it is initially surprising to see that LIAONING ENERGY INDUSTRYLTD's EBIT has low interest coverage of 2.5 times. So one way or the other, it's clear the debt levels are not trivial. Importantly, LIAONING ENERGY INDUSTRYLTD's EBIT fell a jaw-dropping 47% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is LIAONING ENERGY INDUSTRYLTD'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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, LIAONING ENERGY INDUSTRYLTD actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

We'd go so far as to say LIAONING ENERGY INDUSTRYLTD's EBIT growth rate was disappointing. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making LIAONING ENERGY INDUSTRYLTD stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for LIAONING ENERGY INDUSTRYLTD you should know about.

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.