These 4 Measures Indicate That China Three Gorges Renewables (Group)Ltd (SHSE:600905) Is Using Debt Extensively

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that China Three Gorges Renewables (Group) Co.,Ltd. (SHSE:600905) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for China Three Gorges Renewables (Group)Ltd

How Much Debt Does China Three Gorges Renewables (Group)Ltd Carry?

As you can see below, at the end of March 2024, China Three Gorges Renewables (Group)Ltd had CN¥160.6b of debt, up from CN¥129.9b a year ago. Click the image for more detail. However, it does have CN¥6.58b in cash offsetting this, leading to net debt of about CN¥154.0b.

How Healthy Is China Three Gorges Renewables (Group)Ltd's Balance Sheet?

According to the last reported balance sheet, China Three Gorges Renewables (Group)Ltd had liabilities of CN¥42.5b due within 12 months, and liabilities of CN¥182.9b due beyond 12 months. Offsetting these obligations, it had cash of CN¥6.58b as well as receivables valued at CN¥41.2b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥177.6b.

Given this deficit is actually higher than the company's massive market capitalization of CN¥133.1b, we think shareholders really should watch China Three Gorges Renewables (Group)Ltd'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

China Three Gorges Renewables (Group)Ltd has a rather high debt to EBITDA ratio of 6.8 which suggests a meaningful debt load. However, its interest coverage of 3.9 is reasonably strong, which is a good sign. The good news is that China Three Gorges Renewables (Group)Ltd improved its EBIT by 3.9% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Three Gorges Renewables (Group)Ltd'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.

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. During the last three years, China Three Gorges Renewables (Group)Ltd burned a lot of cash. 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, China Three Gorges Renewables (Group)Ltd's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think China Three Gorges Renewables (Group)Ltd has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with China Three Gorges Renewables (Group)Ltd (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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.