Does Inner Mongolia MengDian HuaNeng Thermal Power (SHSE:600863) Have A Healthy Balance Sheet?

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 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. As with many other companies Inner Mongolia MengDian HuaNeng Thermal Power Corporation Limited (SHSE:600863) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Inner Mongolia MengDian HuaNeng Thermal Power

What Is Inner Mongolia MengDian HuaNeng Thermal Power's Debt?

As you can see below, Inner Mongolia MengDian HuaNeng Thermal Power had CN¥10.6b of debt at September 2024, down from CN¥14.3b a year prior. However, it also had CN¥1.89b in cash, and so its net debt is CN¥8.69b.

How Strong Is Inner Mongolia MengDian HuaNeng Thermal Power's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Inner Mongolia MengDian HuaNeng Thermal Power had liabilities of CN¥7.54b due within 12 months and liabilities of CN¥7.60b due beyond that. Offsetting this, it had CN¥1.89b in cash and CN¥5.05b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.19b.

While this might seem like a lot, it is not so bad since Inner Mongolia MengDian HuaNeng Thermal Power has a market capitalization of CN¥29.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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).

Inner Mongolia MengDian HuaNeng Thermal Power has a low debt to EBITDA ratio of only 1.5. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. But the other side of the story is that Inner Mongolia MengDian HuaNeng Thermal Power saw its EBIT decline by 3.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Inner Mongolia MengDian HuaNeng Thermal Power can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the last three years, Inner Mongolia MengDian HuaNeng Thermal Power recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Inner Mongolia MengDian HuaNeng Thermal Power's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Taking all this data into account, it seems to us that Inner Mongolia MengDian HuaNeng Thermal Power takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Inner Mongolia MengDian HuaNeng Thermal Power .

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.