Here's Why Huaihe Energy (Group)Ltd (SHSE:600575) Can Manage Its Debt Responsibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Huaihe Energy (Group) Co.,Ltd (SHSE:600575) makes use of debt. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Huaihe Energy (Group)Ltd

How Much Debt Does Huaihe Energy (Group)Ltd Carry?

As you can see below, at the end of June 2024, Huaihe Energy (Group)Ltd had CN¥5.91b of debt, up from CN¥3.66b a year ago. Click the image for more detail. However, it also had CN¥2.66b in cash, and so its net debt is CN¥3.25b.

A Look At Huaihe Energy (Group)Ltd's Liabilities

The latest balance sheet data shows that Huaihe Energy (Group)Ltd had liabilities of CN¥6.12b due within a year, and liabilities of CN¥4.85b falling due after that. Offsetting these obligations, it had cash of CN¥2.66b as well as receivables valued at CN¥1.87b due within 12 months. So it has liabilities totalling CN¥6.44b more than its cash and near-term receivables, combined.

Huaihe Energy (Group)Ltd has a market capitalization of CN¥13.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Huaihe Energy (Group)Ltd's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. In addition to that, we're happy to report that Huaihe Energy (Group)Ltd has boosted its EBIT by 39%, thus reducing the spectre of future debt repayments. 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 Huaihe Energy (Group)Ltd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Huaihe Energy (Group)Ltd recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Huaihe Energy (Group)Ltd's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. It's also worth noting that Huaihe Energy (Group)Ltd is in the Infrastructure industry, which is often considered to be quite defensive. Looking at the bigger picture, we think Huaihe Energy (Group)Ltd's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Huaihe Energy (Group)Ltd you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.