Is China Southern Power Grid Energy Storage (SHSE:600995) A Risky Investment?

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.' 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. As with many other companies China Southern Power Grid Energy Storage Co., Ltd. (SHSE:600995) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for China Southern Power Grid Energy Storage

What Is China Southern Power Grid Energy Storage's Debt?

As you can see below, at the end of March 2024, China Southern Power Grid Energy Storage had CN¥16.0b of debt, up from CN¥11.1b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥3.70b, its net debt is less, at about CN¥12.3b.

A Look At China Southern Power Grid Energy Storage's Liabilities

We can see from the most recent balance sheet that China Southern Power Grid Energy Storage had liabilities of CN¥2.19b falling due within a year, and liabilities of CN¥18.7b due beyond that. On the other hand, it had cash of CN¥3.70b and CN¥598.0m worth of receivables due within a year. So its liabilities total CN¥16.6b more than the combination of its cash and short-term receivables.

China Southern Power Grid Energy Storage has a market capitalization of CN¥29.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

China Southern Power Grid Energy Storage has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, China Southern Power Grid Energy Storage's EBIT was down 42% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Southern Power Grid Energy Storage'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. Over the last three years, China Southern Power Grid Energy Storage 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

On the face of it, China Southern Power Grid Energy Storage's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn't such a worry. We should also note that Electric Utilities industry companies like China Southern Power Grid Energy Storage commonly do use debt without problems. We're quite clear that we consider China Southern Power Grid Energy Storage to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 2 warning signs for China Southern Power Grid Energy Storage (1 is potentially serious!) that you should be aware of before investing here.

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.

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