Is Henan Yuneng HoldingsLtd (SZSE:001896) Using Too Much Debt?

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. We can see that Henan Yuneng Holdings Co.,Ltd. (SZSE:001896) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

See our latest analysis for Henan Yuneng HoldingsLtd

What Is Henan Yuneng HoldingsLtd's Net Debt?

As you can see below, at the end of March 2024, Henan Yuneng HoldingsLtd had CN¥23.9b of debt, up from CN¥22.6b a year ago. Click the image for more detail. On the flip side, it has CN¥2.48b in cash leading to net debt of about CN¥21.4b.

How Healthy Is Henan Yuneng HoldingsLtd's Balance Sheet?

The latest balance sheet data shows that Henan Yuneng HoldingsLtd had liabilities of CN¥13.2b due within a year, and liabilities of CN¥15.2b falling due after that. Offsetting these obligations, it had cash of CN¥2.48b as well as receivables valued at CN¥1.96b due within 12 months. So it has liabilities totalling CN¥24.0b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CN¥5.72b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Henan Yuneng HoldingsLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Henan Yuneng HoldingsLtd shareholders face the double whammy of a high net debt to EBITDA ratio (11.1), and fairly weak interest coverage, since EBIT is just 0.72 times the interest expense. The debt burden here is substantial. However, the silver lining was that Henan Yuneng HoldingsLtd achieved a positive EBIT of CN¥548m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Henan Yuneng HoldingsLtd will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Henan Yuneng HoldingsLtd 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

To be frank both Henan Yuneng HoldingsLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We should also note that Electric Utilities industry companies like Henan Yuneng HoldingsLtd commonly do use debt without problems. After considering the datapoints discussed, we think Henan Yuneng HoldingsLtd has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. To that end, you should be aware of the 1 warning sign we've spotted with Henan Yuneng HoldingsLtd .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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