We Think Top Resource Energy (SZSE:300332) Can Stay On Top Of Its 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. Importantly, Top Resource Energy Co., Ltd. (SZSE:300332) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Top Resource Energy

How Much Debt Does Top Resource Energy Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Top Resource Energy had CN¥1.55b of debt, an increase on CN¥1.38b, over one year. On the flip side, it has CN¥1.16b in cash leading to net debt of about CN¥388.9m.

How Healthy Is Top Resource Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Top Resource Energy had liabilities of CN¥3.47b due within 12 months and liabilities of CN¥1.27b due beyond that. Offsetting these obligations, it had cash of CN¥1.16b as well as receivables valued at CN¥1.14b due within 12 months. So it has liabilities totalling CN¥2.44b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Top Resource Energy has a market capitalization of CN¥5.42b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Top Resource Energy has a low net debt to EBITDA ratio of only 0.43. And its EBIT easily covers its interest expense, being 10.3 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, Top Resource Energy grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Top Resource Energy can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Top Resource Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Top Resource Energy's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. It's also worth noting that Top Resource Energy is in the Gas Utilities industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Top Resource Energy is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Top Resource Energy you should know about.

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.