Shaanxi Energy Investment (SZSE:001286) Has A Somewhat Strained Balance Sheet

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Shaanxi Energy Investment Co., Ltd. (SZSE:001286) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Shaanxi Energy Investment

What Is Shaanxi Energy Investment's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Shaanxi Energy Investment had CN¥25.0b of debt, an increase on CN¥23.9b, over one year. However, it does have CN¥4.56b in cash offsetting this, leading to net debt of about CN¥20.4b.

How Healthy Is Shaanxi Energy Investment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shaanxi Energy Investment had liabilities of CN¥13.5b due within 12 months and liabilities of CN¥21.9b due beyond that. On the other hand, it had cash of CN¥4.56b and CN¥2.13b worth of receivables due within a year. So it has liabilities totalling CN¥28.7b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥38.3b, so it does suggest shareholders should keep an eye on Shaanxi Energy Investment's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Shaanxi Energy Investment has net debt to EBITDA of 2.5 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.9 suggests it can easily service that debt. Importantly Shaanxi Energy Investment's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. 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 Shaanxi Energy Investment's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Shaanxi Energy Investment's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Shaanxi Energy Investment's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Shaanxi Energy Investment's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. We've identified 2 warning signs with Shaanxi Energy Investment , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.