These 4 Measures Indicate That Beijing Jingneng Power (SHSE:600578) Is Using Debt In A Risky Way

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 Beijing Jingneng Power Co., Ltd. (SHSE:600578) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Beijing Jingneng Power

How Much Debt Does Beijing Jingneng Power Carry?

The chart below, which you can click on for greater detail, shows that Beijing Jingneng Power had CN¥45.5b in debt in September 2023; about the same as the year before. On the flip side, it has CN¥4.18b in cash leading to net debt of about CN¥41.3b.

A Look At Beijing Jingneng Power's Liabilities

According to the last reported balance sheet, Beijing Jingneng Power had liabilities of CN¥22.5b due within 12 months, and liabilities of CN¥33.5b due beyond 12 months. On the other hand, it had cash of CN¥4.18b and CN¥5.01b worth of receivables due within a year. So its liabilities total CN¥46.9b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥22.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Beijing Jingneng Power would probably need a major re-capitalization if its creditors were to demand repayment.

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).

Beijing Jingneng Power has a rather high debt to EBITDA ratio of 8.6 which suggests a meaningful debt load. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Notably, Beijing Jingneng Power made a loss at the EBIT level, last year, but improved that to positive EBIT of CN¥1.3b in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Beijing Jingneng Power can strengthen its balance sheet over time. 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. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Beijing Jingneng Power 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

To be frank both Beijing Jingneng Power's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its interest cover is not so bad. After considering the datapoints discussed, we think Beijing Jingneng Power has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. We've identified 2 warning signs with Beijing Jingneng Power , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.