Here's Why Sichuan Xichang Electric PowerLtd (SHSE:600505) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Sichuan Xichang Electric Power Co.,Ltd. (SHSE:600505) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Sichuan Xichang Electric PowerLtd

How Much Debt Does Sichuan Xichang Electric PowerLtd Carry?

You can click the graphic below for the historical numbers, but it shows that Sichuan Xichang Electric PowerLtd had CN¥2.18b of debt in September 2024, down from CN¥2.34b, one year before. However, it also had CN¥263.9m in cash, and so its net debt is CN¥1.92b.

How Strong Is Sichuan Xichang Electric PowerLtd's Balance Sheet?

The latest balance sheet data shows that Sichuan Xichang Electric PowerLtd had liabilities of CN¥966.2m due within a year, and liabilities of CN¥2.01b falling due after that. Offsetting this, it had CN¥263.9m in cash and CN¥278.5m in receivables that were due within 12 months. So its liabilities total CN¥2.43b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sichuan Xichang Electric PowerLtd has a market capitalization of CN¥4.55b, 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 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). 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).

Weak interest cover of 0.88 times and a disturbingly high net debt to EBITDA ratio of 5.1 hit our confidence in Sichuan Xichang Electric PowerLtd like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Sichuan Xichang Electric PowerLtd grew its EBIT at 18% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Sichuan Xichang Electric PowerLtd will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Sichuan Xichang Electric PowerLtd produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

We weren't impressed with Sichuan Xichang Electric PowerLtd's net debt to EBITDA, and its interest cover made us cautious. But its conversion of EBIT to free cash flow was significantly redeeming. We would also note that Electric Utilities industry companies like Sichuan Xichang Electric PowerLtd commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Sichuan Xichang Electric PowerLtd's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should be aware of the 2 warning signs we've spotted with Sichuan Xichang Electric PowerLtd .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.