Is Huadian Energy (SHSE:600726) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Huadian Energy Company Limited (SHSE:600726) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Huadian Energy

How Much Debt Does Huadian Energy Carry?

As you can see below, Huadian Energy had CN¥14.2b of debt at March 2024, down from CN¥15.8b a year prior. However, it also had CN¥3.78b in cash, and so its net debt is CN¥10.4b.

A Look At Huadian Energy's Liabilities

We can see from the most recent balance sheet that Huadian Energy had liabilities of CN¥11.0b falling due within a year, and liabilities of CN¥11.3b due beyond that. Offsetting these obligations, it had cash of CN¥3.78b as well as receivables valued at CN¥1.56b due within 12 months. So its liabilities total CN¥17.0b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CN¥15.4b, we think shareholders really should watch Huadian Energy's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Huadian Energy's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 3.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Huadian Energy's EBIT flopped 11% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Huadian Energy 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Huadian Energy recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Neither Huadian Energy's ability to handle its total liabilities nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Huadian Energy is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Huadian Energy has 2 warning signs we think 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com