Here's Why China Yangtze Power (SHSE:600900) Can Manage Its Debt Responsibly

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. As with many other companies China Yangtze Power Co., Ltd. (SHSE:600900) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for China Yangtze Power

What Is China Yangtze Power's Net Debt?

The image below, which you can click on for greater detail, shows that China Yangtze Power had debt of CN¥303.5b at the end of September 2024, a reduction from CN¥335.4b over a year. However, because it has a cash reserve of CN¥6.56b, its net debt is less, at about CN¥297.0b.

A Look At China Yangtze Power's Liabilities

We can see from the most recent balance sheet that China Yangtze Power had liabilities of CN¥170.4b falling due within a year, and liabilities of CN¥177.1b due beyond that. On the other hand, it had cash of CN¥6.56b and CN¥13.0b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥328.0b.

While this might seem like a lot, it is not so bad since China Yangtze Power has a huge market capitalization of CN¥670.9b, 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 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).

China Yangtze Power has net debt to EBITDA of 4.3 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.5 suggests it can easily service that debt. We note that China Yangtze Power grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine China Yangtze Power's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, China Yangtze Power actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, China Yangtze Power's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its net debt to EBITDA has the opposite effect. When we consider the range of factors above, it looks like China Yangtze Power is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - China Yangtze Power has 1 warning sign we think you should be aware of.

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.