These 4 Measures Indicate That Sichuan Xichang Electric PowerLtd (SHSE:600505) Is Using Debt In A Risky Way

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Sichuan Xichang Electric Power Co.,Ltd. (SHSE:600505) does carry debt. 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. 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.

See our latest analysis for Sichuan Xichang Electric PowerLtd

What Is Sichuan Xichang Electric PowerLtd's Net Debt?

As you can see below, Sichuan Xichang Electric PowerLtd had CN¥2.33b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥253.7m in cash leading to net debt of about CN¥2.08b.

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

We can see from the most recent balance sheet that Sichuan Xichang Electric PowerLtd had liabilities of CN¥972.0m falling due within a year, and liabilities of CN¥2.12b due beyond that. Offsetting these obligations, it had cash of CN¥253.7m as well as receivables valued at CN¥227.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.61b.

This deficit is considerable relative to its market capitalization of CN¥3.93b, so it does suggest shareholders should keep an eye on Sichuan Xichang Electric PowerLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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 0.59 times and a disturbingly high net debt to EBITDA ratio of 6.6 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. Worse, Sichuan Xichang Electric PowerLtd's EBIT was down 53% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sichuan Xichang Electric PowerLtd's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Sichuan Xichang Electric PowerLtd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Sichuan Xichang Electric PowerLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its net debt to EBITDA fails to inspire much confidence. We should also note that Electric Utilities industry companies like Sichuan Xichang Electric PowerLtd commonly do use debt without problems. After considering the datapoints discussed, we think Sichuan Xichang Electric PowerLtd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For instance, we've identified 3 warning signs for Sichuan Xichang Electric PowerLtd that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.